If you borrow money to buy investments, the interest you pay may qualify as an investment interest expense deduction. However, not all interest expenses are eligible.
Investment interest expense generally includes interest paid on money borrowed to purchase taxable investments. Certain types of interest, though, are specifically excluded under IRS rules.
What Is Not Considered an Investment Interest Expense?
The following types of interest cannot be claimed as investment interest expense:
Personal Interest
Personal interest is generally not deductible and does not qualify as investment interest expense. This includes:
- Credit card interest on personal purchases
- Auto loan interest for personal vehicles
- Most other personal borrowing costs
- Qualified residence interest (home mortgage interest), which is subject to its own tax rules
Interest Related to Passive Activities
Interest expenses connected to passive activities aren't considered investment interest expense.
A passive activity is typically a trade or business in which you do not materially participate. For example, if you're merely an investor in a business and aren't actively involved in its operations, related interest expenses may be subject to passive activity rules instead.
Capitalized Interest
Certain interest expenses must be added to the cost of an asset rather than deducted currently.
One common example is construction interest that must be capitalized under IRS rules. When interest is capitalized, it becomes part of the asset's basis instead of an immediate deduction.
Interest Connected to Tax-Exempt Income
You generally can't deduct interest expenses incurred to earn tax-exempt income.
For example, if you borrow money to purchase tax-exempt municipal bonds, the related interest expense is typically not deductible as investment interest expense.
Certain Life Insurance, Endowment, and Annuity Contract Interest
Interest that is disallowed under IRS rules for indebtedness related to certain:
- Life insurance contracts
- Endowment contracts
- Annuity contracts issued after June 8, 1997
does not qualify as investment interest expense, even if the borrowed funds were used to acquire investment property.
What Is Property Held for Investment?
The IRS generally considers property held for investment to include property that generates income such as:
- Interest
- Dividends
- Annuities
- Royalties
It can also include property held with the expectation of producing a gain or loss when sold, as long as the activity isn't part of the ordinary course of a trade or business.
For example, stocks, bonds, and other investment assets are commonly considered property held for investment.
What Is Not Property Held for Investment?
An interest in a passive activity generally isn't considered property held for investment for purposes of the investment interest expense rules.
This distinction is important because passive activity expenses are subject to a separate set of tax limitations and reporting requirements.