Lower Taxes with this Overlooked Deduction

A long, long time ago, the Internal Revenue Service permitted taxpayers to deduct all of their interest charges, including interest paid on credit cards. Now however, it is possible to only deduct certain types of interest and one cannot lower taxes as was previously possible. Probably the most evident deduction is home loan and home equity loan interest. But investment interest expenses are also tax-deductible - and often ignored as a means to lower taxes.

Investment interest is interest incurred when you borrow against your investment account. These rates are low--usually about the same as mortgage interest. How much you can deduct is limited by your investment income. Borrowing can be used to buy more investments or for anything you want--home improvements, vacations, etc. In all cases, the investment interest deduction can potentially help you lower taxes.

Investment income includes interest (e.g. interest on bonds) and short-term capital gains. However, you have the option to also include qualified dividends and long-term capital gains in your definition of investment income. By having more investment income, you can take a larger deduction for investment interest you pay.

But, if you opt for this expanded definition of investment income, that includes qualified dividends and long-term capital gains, the long-term capital gains and dividends will then be treated as investment income and subject to taxes at your regular tax rate - which may be greater than the 15% tax rate for qualified dividends and long-term capital gains. This means you likely have to see a tax advisor to help lower taxes with this particular strategy. It pays for some but not others.

Once you borrow money to purchase taxable investments - for example, when you purchase stocks on margin - the interest you pay on that loan is known as an investment interest expense. You can deduct this interest to the extent of one's taxable investment income - that is, income from interest and short-term capital gains. In case your investment interest expense exceeds your taxed investment income, the surplus interest cost can be carried over to the next tax yr. So you not only lower taxes this yr but possibly later on.

Additionally be aware that we mentioned interest on financial loans used to buy taxed investments is deductible. Interest on financial loans used to purchase non-taxable investments, including municipal bonds or municipal bond funds, isn't deductible.(A little tax-planning here can indeed allow you to borrow money, deduct the interest and ultimately use the funds to buy tax-free bonds. When the loan proceeds aren't directly used to purchase tax-free bonds yet the loan proceeds free up other finances to purchase tax-free investments, it gets challenging to monitor by IRS. Speaking to your tax consultant to lower taxes this way is recommended).

What does this mean? In case you have to borrow to purchase investments (or anything else), it might be considered a great way to lower taxes -- to make use of money to buy the non-taxable investments, and use the loan proceeds to purchase the taxable investments.