DEFINITION of 'Form 4952: Investment Interest Expense Deduction'

A tax form distributed by the Internal Revenue Service (IRS) used to determine the amount of investment interest expense that can be deducted and any interest expense that can be carried forward to a future tax year. Form 4952 limits the investment interest expense deduction for an individual, estate or trust to its net income from investment.

BREAKING DOWN 'Form 4952: Investment Interest Expense Deduction'

The IRS has different rules taxpayers must follow, depending on where interest comes from and whether it is investment, personal, business or mortgage-related. If an investor pays or accrues interest on a loan and then uses the proceeds for several different purposes, the taxpayer may have to allocate the interest to ensure that the right interest rule is used.

Interest income may result from money borrowed specifically to purchase investments like parcels of land, commercial or residential investment properties, stocks and non-tax-exempt bonds. However interest income does not include interest generated from vehicles that yield tax-exempt income, such as annuities, municipal bonds or life insurance products. 

Interest types that are non-deductible

Other types of interest that may not be deducted on Form 4982 include any interest expenses that are properly allocable to passive activities, which the IRS defines as rental activities or any businesses in which taxpayers do not materially participate. Passive activities directly counter passive activities, where taxpayers work on consistent, substantial and continuous bases. The IRS prohibits taxpayers from deducting investment interest incurred to produce tax-exempt income or from money borrowed to buy tax-exempt securities or shares in mutual funds or other regulated investment companies that distribute exempt-interest dividends. In addition, passive income does not include salaries, portfolio, or investment income.

Taxpayers usually may not include qualified dividends or long-term capital gains as investment income, because they are already receiving tax breaks on these items, which are taxed at lower rates than most other income. Depending on an individual’s tax bracket, he or she may enjoy the lower tax rate of 0%, 15% or 20%.

There are rules in place that limit the amount of investment interest a taxpayer may deduct. For example, one may not deduct more investment interest than the net investment income reported. Pointedly: net investment income is deemed investment expenses one may subtract from items such as royalties, short-term capital gains, and dividend payments.

For more information on this credit, see IRS Publication 503.

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