The IRS allows various tax deductions for expenses related to producing taxable investment income. Do yours qualify?
Since maximizing your tax deductions has the potential to reduce your tax burden, let's look at some of the most common deductible investment expenses and how they can reduce your taxable income.
For tax years 2018 to 2025, "miscellaneous itemized deductions" have been eliminated. Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), taxpayers were allowed to deduct expenses such as fees for investment advice, IRA custodial fees, and accounting costs necessary to produce or collect taxable income.
If you itemize, you may be able to deduct the interest paid on money you borrowed to purchase taxable investments—for example, margin loans to buy stock or loans to buy investment property. However, you wouldn't be allowed to deduct the interest on a loan to buy tax-advantaged investments such as municipal bonds.
The amount that you can deduct is capped at your net taxable investment income for the year. Any leftover interest expense gets carried forward to the next year and can potentially be used to reduce your taxes in the future.
To determine your deductible investment interest expense, you need to know the following:
Let's look at an example. Here, Mary has $150,000 of total income, $8,000 of net investment income (from ordinary dividends and interest income), $10,500 of investment interest expenses from a margin loan, and $13,000 of other itemized deductions (such as mortgage interest and state taxes).
*Example assumes that Mary itemizes deductions.
The example is hypothetical and provided for illustrative purposes only.
Because of the investment interest expense deduction and other itemized deductions, Mary's taxable income has been reduced from $150,000 to $129,000.
Qualified dividends that receive preferential tax treatment aren't considered investment income for these purposes. However, you can opt to have your qualified dividends treated as ordinary income.
In the right circumstances, electing to treat qualified dividends as ordinary income can increase your investment interest expense deduction, which could allow you to pay 0% tax on the dividends instead of the 15% or 20% tax that qualified dividends normally receive. Here's an example of how it might work.
In addition to the information in the first example, let's say Mary has $2,000 of qualified dividends, on which she would normally pay $300 in tax ($2,000 x 15% long-term capital gains tax rate). If Mary elected instead to treat the qualified dividends as ordinary income, she could boost her net investment income from $8,000 to $10,000. As a result, she would be able to deduct more of her investment interest expense in the current year—and pay no tax on the qualified dividends.
