Save Tax with this Overlooked Deduction?

A long, long time ago, the Internal Revenue Service allowed taxpayers to deduct all their interest charges, even credit card interest - but today, it is possible to solely deduct certain kinds of interest and cannot save tax as was previously possible. Probably the most evident deduction is home mortgage and home equity loan interest. But investment interest expenses also are tax-deductible - and often ignored as a means to save tax.

Once you lend money to buy taxed investments - for instance, once you buy shares on margin - the interest you pay on that loan is called an investment interest cost. You are able to deduct this interest to the extent of your taxable investment income - that's, income from interest and short-term capital gains. In case your investment interest expense is much greater than your taxed investment income, the surplus interest expense may be carried over to the next tax yr. So you not just save tax this year but probably later on.

Why do we say your taxed investment income includes interest and short-term capital gains, but not point out other evident investment income, including certified returns and long-term capital gains? This is where the law gets tricky. In case you want, you might treat all or part of your qualified dividends and long-term capital gains as investment income. This, clearly, will allow you to possibly deduct more of your investment-interest cost. The issue: The long-term capital gains and certified dividends will then be treated as investment income, and be subject to taxes at your regular tax rate - which may be greater than the 15% tax rate for certified dividends and long-term capital gains, depending on your tax bracket. Which means you most likely have to visit a tax advisor to assist save tax with this technique. It pays for some but not others.

Also note that we said interest on financial loans utilized to purchase taxable investments is deductible. Interest on loans utilized to purchase non-taxable investments, including municipal bonds or municipal bond funds, is not deductible.(However, when the loan proceeds aren't directly used to purchase tax free bonds but the proceeds free up other funds to buy tax free investments, it becomes challenging to monitor by IRS. Speaking to your tax consultant to save tax this way is recommended).

What does this mean? If you need to borrow to purchase investments, it might be considered a great way to save tax -- to use money to buy the non-taxable investments, and utilized the loan proceeds to purchase the taxable investments.