How to Tackle a Thorny Investment Tax Issue
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Q: I have a taxable account at a discount brokerage, and I purchase stocks on margin. How do I write off the margin interest? – William, Northport, Fla.
A: You can deduct all kinds of expenses related to investing, and that includes margin interest. But, as you would probably expect, there are some caveats.
For one thing, before you can deduct margin interest you’ll need to first calculate your net investment income by subtracting any other related write offs. “If you made $1,000 in dividends and have spent $800 on deductible investment expenses, that means you can deduct no more than $200 in margin interest,” says Leon LaBrecque, a CPA and CFP, and managing partner of LJPR in Troy, Mich.
These expenses must be reasonable and necessary, and typically include such costs as investment advisory fees, safety-deposit box rentals, and subscriptions for research or investment-related publications. If you have investment losses or costs associated with real estate investments (but not rental property), those get factored in here too.
You’ll of course need to itemize your deductions, rather than taking the standard deduction. If your interest paid should happen to exceed your net investment come in any given year, you can carry it over to the next.
Keep in mind too that “you can only deduct what you’ve actually earned in taxable investment income,” LaBrecque says. Eligible investment income includes interest, stock dividends, capital gains and royalties. It doesn’t include tax-exempt securities, such as municipal bonds, or option straddles. Note: if you include long-term capital gains or qualified dividends in this equation, you give up the more favorable (15%) rate, “but in some circumstances it might make sense to do that,” LaBrecque adds.
Finally, you can only deduct margin interest if you used the proceeds to generate (or attempt to generate) taxable income. If you used a margin to buy tax-exempt bonds or sail around the world, none of that interest is deductible.
Of course, relative to investing with borrowed money, figuring out how to deduct the interest should be a cakewalk. Buying securities with margin is risky business. “There’s not just the chance that you’ll lose money, but that you’ll owe money,” says LaBrecque. “If a stock goes down enough you can really get wiped out.”