Interest Expenses This section discusses interest expenses you may be able to deductas an investor. For information on business interest, see chapter 5 of Publication 535. You cannot deduct personal interest expenses other than qualifiedhome mortgage interest, as explained in Publication 936, and intereston certain student loans, as explained in Publication 970, TaxBenefits for Higher Education. Investment Interest If you borrow money and use it to buy property you hold forinvestment, the interest you pay is investment interest. You candeduct investment interest subject to the limit discussed later.However, you cannot deduct interest you incurred to produce tax-exemptincome. See Tax-exempt income under NondeductibleExpenses, later. Nor can you deduct interest expenses onstraddles, also discussed under Nondeductible Expenses. Investment interest does not include any qualified home mortgageinterest or any interest taken into account in computing income orloss from a passive activity. Investment property.Property held for investment includes property that producesinterest, dividends, annuities, or royalties not derived in theordinary course of a trade or business. It also includes property thatproduces gain or loss (not derived in the ordinary course of a tradeor business) from the sale or trade of property producing these typesof income or held for investment (other than an interest in a passiveactivity). Investment property also includes an interest in a trade orbusiness activity in which you did not materially participate (otherthan a passive activity). Partners, shareholders, and beneficiaries.To determine your investment interest, combine your share ofinvestment interest from a partnership, S corporation, estate, ortrust with your other investment interest. Allocation of Interest Expense If you use borrowed money for business or personal purposes as wellas for investment, you must allocate the debt among those purposes.Only the interest expense on the part of the debt used for investmentpurposes is treated as investment interest. The allocation is notaffected by the use of property that secures the debt. However, fullydeductible home mortgage interest is not treated as investmentinterest and the debt does not have to be allocated, regardless of howthe proceeds are used. Example 1.You borrow $10,000 and use $8,000 to buy stock. You use the other$2,000 to buy items for your home. Since 80% of the debt is used for,and allocated to, investment purposes, 80% of the interest on thatdebt is investment interest. The other 20% is nondeductible personalinterest. Debt proceeds received in cash.Interest you pay on debt proceeds that you received in cash isgenerally treated as nondeductible personal interest. However, you cantreat any payment you make within 30 days before or after you receivethe proceeds as made from those proceeds. This applies to any payment(up to the amount of the proceeds) made from any account you own, orfrom cash. Also, you can treat the payment as made on the date youreceived the cash instead of on the date you actually made thepayment. Debt proceeds deposited in account.If you deposit debt proceeds in an account, that deposit is treatedas an investment expenditure. Amounts held in the account are treatedas investment property, regardless of whether the account bearsinterest. Any interest you pay on the deposited proceeds is investmentinterest. But, if you withdraw the funds and use them for anotherpurpose, you must reallocate the debt and any interest you pay. Example 2.Assume in Example 1 that you borrowed the money on March1 and immediately bought the stock for $8,000. You did not buy thehousehold items until June 1. You had deposited the $2,000 in thebank. You had no other transactions on the bank account and made noprincipal payments on the debt. The $2,000 is treated as being usedfor an investment purpose for the 3-month period. Your total interestexpense for 3 months on this debt is investment interest. In June, youmust begin to allocate 80% of the debt and the interest expense toinvestment purposes and 20% to personal purposes. Payments on debt require new allocation.As you repay the debt, you must reallocate the balance. You mustfirst reduce the amount allocated to personal purposes by therepayment. You then reallocate the rest of the debt to find what partis for investment purposes. Example 3.If, in Example 2, you repay $500 on November 1, theentire repayment is applied against the amount allocated to personalpurposes. The debt balance is now allocated as $8,000 for investmentpurposes, and $1,500 for personal purposes. Until the nextreallocation is necessary, 84% ($8,000 $9,500) of the debtand the interest expense is allocated to investment. Pass-through entities.If you use borrowed funds to buy an interest in a partnership or Scorporation, then the interest on those funds must be allocated basedon the assets of the entity. If you contribute to the capital of theentity, you can make the allocation using any reasonable method. Additional allocation rules.For more information about allocating interest expense, see chapter 5 of Publication 535. When To DeductInvestment Interest If you use the cash method of accounting, you must pay the interestbefore you can deduct it. If you use an accrual method of accounting, you can deduct interestover the period it accrues, regardless of when you pay it. For anexception, see Unpaid expenses owed to related party underWhen To Report Investment Expenses, later in this chapter. Example.You borrowed $1,000 on September 6, 2000, payable in 90 days at 12%interest. On December 5, 2000, you paid this with a new note for$1,030, due on March 5, 2001. If you use the cash method ofaccounting, you cannot deduct any part of the $30 interest on yourreturn for 2000 because you did not actually pay it. If you use anaccrual method, you may be able to deduct a portion of the interest onthe loans through December 31, 2000, on your return for 2000. Interest paid in advance.Generally, if you pay interest in advance for a period that goesbeyond the end of the tax year, you must spread the interest over thetax years to which it belongs under the OID rules. You can deduct ineach year only the interest for that year. Interest on margin accounts.If you are a cash method taxpayer, you can deduct interest onmargin accounts to buy taxable securities as investment interest inthe year you paid it. You are considered to have paid interest onthese accounts only when you actually pay the broker or when paymentbecomes available to the broker through your account. Payment maybecome available to the broker through your account when the brokercollects dividends or interest for your account, or sells securitiesheld for you or received from you. You cannot deduct any interest on money borrowed for personalreasons. Deferral of interest deduction for market discount bonds.The amount you can deduct for interest expense you paid or accruedduring the year to buy or carry a market discount bond may be limited.This limit does not apply if you accrue the market discount andinclude it in your income currently. Under this limit, the interest is deductible only to the extent itis more than: The total interest and OID includible in gross income forthe bond for the year, plus The market discount for the number of days you held the bondduring the year. Figure the amount in (2) above using the rules for figuringaccrued market discount in chapter 1under Market DiscountBonds. Disallowed interest expense.In the year you dispose of the bond, you can deduct the amount ofany interest expense you were not allowed to deduct in earlier years. Choosing to deduct disallowed interest expense before theyear of disposition.You can choose to deduct disallowed interest expense in any yearbefore the year you dispose of the bond, up to your net interestincome from the bond during the year. The rest of the disallowedinterest expense remains deductible in the year you dispose of thebond. Net interest income.This is the interest income (including OID) from the bond that youinclude in income for the year, minus the interest expense paid oraccrued during the year to purchase or carry the bond. Deferral of interest deduction for short-term obligations.If the current income inclusion rules discussed in chapter 1underDiscount on Short-Term Obligations do not apply to you, theamount you can deduct for interest expense you paid or accrued duringthe year to buy or carry a short-term obligation is limited. The interest is deductible only to the extent it is more than: The amount of acquisition discount or OID on the obligationfor the tax year, plus The amount of any interest payable on the obligation for theyear that is not included in income because of your accounting method(other than interest taken into account in determining the amount ofacquisition discount or OID). The method of determining acquisition discount and OID forshort-term obligations is discussed in chapter 1under Discounton Short-Term Obligations. Disallowed interest expense.In the year you dispose of the obligation, or if you choose, inanother year in which you have net interest income from theobligation, you can deduct the amount of any interest expense you werenot allowed to deduct for an earlier year. Follow the same rulesprovided in the earlier discussion under Deferral of interestdeduction for market discount bonds. Limit on Deduction Generally, your deduction for investment interest expense islimited to the amount of your net investment income. You can carry over the amount of investment interest that you couldnot deduct because of this limit to the next tax year. The interestcarried over is treated as investment interest paid or accrued in thatnext year. You can carry over disallowed investment interest to the next taxyear even if it is more than your taxable income in the year theinterest was paid or accrued. Net Investment Income Determine the amount of your net investment income by subtractingyour investment expenses (other than interest expense) from yourinvestment income. Investment income.This generally includes your gross income from property held forinvestment (such as interest, dividends, annuities, and royalties).Investment income does not include Alaska Permanent Fund dividends. Choosing to include net capital gain.Investment income generally does not include net capital gain fromdisposing of investment property (including capital gain distributionsfrom mutual funds). However, you can choose toinclude all or part of your net capital gain in investment income. You make this choice by completing line 4e of Form 4952 accordingto its instructions. If you choose to include any amount of your net capital gain ininvestment income, you must reduce your net capital gain that iseligible for the lower capital gains tax rates by the same amount. For more information about the capital gains rates, seeCapital Gain Tax Rates in chapter 4. TaxTip: Before making this choice, consider the overall effect on your taxliability. Compare your tax if you make this choice with your tax ifyou do not. Investment income of child reported on parent's return.Investment income includes the part of your child's interest anddividend income that you choose to report on your return. If the childdoes not have Alaska Permanent Fund dividends or capital gaindistributions, this is the amount on line 6 of Form 8814,Parents' Election To Report Child's Interest andDividends. Example. Your 8-year-old son has interest income of $2,000, which you chooseto report on your own return. You enter $2,000 on lines 1a and 4 ofForm 8814 and $600 on line 6 of Form 8814 and line 21 of Form 1040.Your investment income includes this $600. Child's Alaska Permanent Fund dividends. If part of the amount you report is your child's Alaska PermanentFund dividends, that part does not count as investment income. Tofigure the amount of your child's income that you can consider yourinvestment income, start with the amount on line 6 of Form 8814.Multiply that amount by a percentage that is equal to the AlaskaPermanent Fund dividends divided by the total amount on line 4 of Form8814. Subtract the result from the amount on line 6 of Form 8814. Example.Your 10-year-old child has interest and dividend income of $4,000,including $500 in Alaska Permanent Fund dividends. You choose toreport this on your return. You enter $4,000 on line 4 of Form 8814and $2,600 on line 6 of Form 8814 and line 21 of Form 1040. You figurethe amount of your child's income that you can consider yourinvestment income as follows: $2,600 - ($2,600 ($500 $4,000)) = $2,275 Child's capital gain distributions. If your child has capital gain distributions, fill out thefollowing worksheet before completing Form 4952. Worksheet (Keep for your records) 1. Enter amount from Form 8814, line 3            2. Enter amount from Form 8814, line 4            3. Divide line 1 by line 2            4. Base amount     $1,400 5. Subtract line 4 from line 2            6. Multiply line 5 by the decimal on line 3. Enterthe result here. Also include it in figuring the amounts to enter onlines 4b and 4c of Form 4952.            7. Subtract line 6 from line 5. Enter the resulthere. Also include it on line 4a of Form 4952.            Example.Your 9-year old daughter has ordinary dividends of $1,360 and a$340 capital gain distribution from a mutual fund. You choose toreport this income on your tax return. On Form 8814, you enter $1,360on line 2, $340 on line 3, $1,700 on line 4, and $300 on line 6. Thenyou fill out the worksheet above. The amount on line 7 of theworksheet ($240) is investment income, which you include on line 4a ofForm 4952. The amount on line 6 of the worksheet ($60) is included onlines 4b and 4c of Form 4952. You must decide whether to make thechoice to include this $60 in investment income on line 4e. Investment expenses.Investment expenses include all income-producing expenses (otherthan interest expense) relating to the investment property that areallowable deductions after applying the 2% limit that applies tomiscellaneous itemized deductions. Use the smaller of: The investment expenses included on line 22 of Schedule A(Form 1040), or The amount on line 26 of Schedule A. See Expenses of Producing Income, later, for adiscussion of the 2% limit. Losses from passiveactivities.Income or expenses that you used in computing income or loss from apassive activity are not included in determining your investmentincome or investment expenses (including investment interest expense).See Publication 925 for information about passive activities. Example.Ted is a partner in a partnership that operates a business.However, he does not materially participate in the partnership'sbusiness. Ted's interest in the partnership is considered a passiveactivity. Ted's investment income from interest and dividends is $10,000. Hisinvestment expenses (other than interest) are $3,200 after taking intoaccount the 2% limit on miscellaneous itemized deductions. Hisinvestment interest expense is $8,000. Ted also has income from thepartnership of $2,000. Ted figures his net investment income and the limit on hisinvestment interest expense deduction in the following way: Total investment income $10,000 Minus: Investment expenses (other thaninterest)      3,200 Net investment income     $6,800 Deductible investment interest expense for theyear     $6,800 The $2,000 of income from the passive activity is not used indetermining Ted's net investment income. His investment interestdeduction for the year is limited to $6,800, the amount of his netinvestment income. Form 4952 Use Form 4952, Investment Interest Expense Deduction, tofigure your deduction for investment interest. Example.Jane Smith is single. Her 2000 income includes $3,000 in dividendsand a net capital gain of $9,000 from the sale of investment property.She incurred $12,500 of investment interest expense. Her otherinvestment expenses directly connected with the production ofinvestment income total $980 after applying the 2% limit onmiscellaneous itemized deductions on Schedule A (Form 1040). For 2000, Jane chooses to include all of her net capital gain ininvestment income. Her total investment income is $12,000 ($3,000dividends + $9,000 net capital gain). Her net investment income is$11,020 ($12,000 total investment income - $980 other investmentexpenses). Jane's Form 4952 is illustrated at the end of the chapter. Herinvestment interest expense deduction is limited to $11,020, theamount of her net investment income. The $1,480 disallowed investmentinterest expense is carried forward to 2001. Exception to use of Form 4952.You do not have to complete Form 4952 or attach it to your returnif you meet all of the following tests. Your investment interest expense is not more than yourinvestment income from interest and ordinary dividends. You do not have any other deductible investmentexpenses. You have no carryover of investment interest expense from1999. If you meet all of these tests, you can deduct all of yourinvestment interest.