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Itemized Deductions from A to Z, Part 5: Investigating Deductions and Investment Interest

This is part five in our series on Itemized Deductions. To read the rest of the series, click here. For additional information regarding 2014 tax planning, you can download our 2014 Tax Planning Guide from the Resources tab on our website.

Interest paid on debts to acquire investment assets is deductible but limited to net investment income. What is considered investment income? Interest, dividends (qualified dividends are not), royalties, annuities, as well as non-passive investments such as working interests in oil and gas properties. Tax-exempt interest and dividends do not qualify. Passive activities like rentals and passive interests in partnerships are not considered investment income.

Investment income is reduced by qualifying expenses to arrive at net investment income. Expenses are first reduced by a 2% floor as a miscellaneous itemized deduction, and then the remainder is deducted against income to arrive at net investment income. As an example, if you have $5,000 in interest income and $1,000 in expenses after the 2% limitation, net investment income would be $4,000. You would be able to deduct up to $4,000 in investment interest.

Any disallowed investment interest is carried forward until used.

Planning Tip:
Investment income does not include qualified dividends or capital gains. However, you can elect to treat those income items as investment income if you forgo favorable capital gains treatment. Sometimes making this election and deducting the interest can produce a beneficial outcome. Run the numbers both ways, and pick the best result.

Next time we’ll begin to address charitable contributions.