Investment interest is interest on money you borrow specifically for buying property you hold for investments that yield taxable income. Common examples of the investments included are:

• Stocks
• Non-tax-exempt bonds
• Land or other investment property

This doesn't include straddles or anything that yields tax-exempt income, like:

• Municipal bonds
• Life insurance
• Annuities

If the loan on stock comes from a broker, it’s usually a margin account. If you used part of a home-equity loan or line of credit to buy the investment, don’t count the interest on that loan toward investment interest if you can deduct it as home-mortgage interest. Also, investment interest doesn't include interest related to a passive activity.

If you borrow money and use only part of it for investment purposes, you must allocate the interest between the various uses. The allocation is based on how much of the loan is used for each purpose.

Ex: Mary borrows $10,000, and uses 20% ($2,000) of it for investments and 80% ($8,000) to pay off her credit cards. In the loan’s first year, she pays a total of $600 in interest. Of the $600 she paid, $120 (20%) of it is investment interest. The rest of the interest ($480) isn't deductible.

You usually can't deduct interest you haven't paid or prepaid interest. Even if you know how much interest you’ll be paying, you can't deduct that interest even if it applied to a loan you had during the year.

Ex: Ken took some money out of his margin account in November 2012, and plans to pay off the loan by the end of February 2013. By the end of 2012, 2 months of interest will have accrued. However, since he hasn’t paid the interest, he can't deduct it.

When Ken pays off the loan in February 2013, he'll receive a statement from his broker reporting the margin interest he received. Since he’ll report this income on his 2013 return, he can deduct the interest at that time based on the investment interest deduction rules.

Rules exist limiting the amount of investment interest you can deduct. The amount of investment interest you can deduct can't be more than the amount of net investment income you report. For this deduction, net investment income is investment expenses subtracted from items like:

• Interest
• Dividends
• Short-term capital gains
• Royalties

You usually can't include qualified dividends or long-term capital gains as investment income. You're already getting a tax break on them since they're taxed at a lower rate than ordinary income. The lower rate might be 0% or 15% depending on your tax bracket.

However, when you prepare your taxes, you can designate these types of income as investment income:

• Qualified dividends
• Long-term capital gains

Then you can include this amount when figuring your net investment income.

However, after you decide this, you won’t receive the lower tax rates that qualified dividends and long-term capital gains usually receive. They will now be taxed at the same rate as all your other income. The advantage of this is that you'll be able to deduct more investment interest.

However, if you don’t allocate any qualified dividends or long-term gains to ordinary income, you can carry over any investment interest expense you couldn't use. You need to decide which option will lower your taxes over a period of time.

Ex: Rod has an investment interest expense of $2,400. His net investment income is:

• Interest of $1,300
• Qualified dividends of $750
• Long-term capital gains of $2,000

The total amount of expenses he can deduct is $1,300 (the amount of the interest income), ignoring the qualified dividends and the long-term capital gains. He has $1,100 ($2,400 - $1,300) of remaining investment interest expenses. He can elect to treat the $2,000 of long-term capital gains as investment income. If he does, he’ll have enough investment income to allow a deduction of the full $2,400 in investment interest expenses. However, this will make $900 ($1,300 in investment interest + $2,000 of long-term capital gain – $2,400 investment interest expenses) of long-term capital gains subject to ordinary income tax rates.

Rod wouldn’t want to elect to treat the qualified dividends as investment income. He could get enough investment income to allow him to deduct all investment interest expenses by adding only the long-term capital gains to the interest income. Not making the election for the qualified dividends allows Rod to still receive the reduced capital gain rate on the qualified dividends.

You deduct investment interest on Schedule A with your other itemized deductions. To deduct investment interest, you must file a Form 4952 with your return. On this form, calculate the amount of investment interest you can deduct, as well as the amount, if any, to be carried over to future years. Also, this is where you designate the amount of qualified dividends and long-term capital gains you want to treat as investment income.

To learn more, see IRS Publication 550: Investment Income and Expenses.