Question

Frank is an avid investor. He borrows money to make investments during the year, he incurred $3,500 of interest expense. During the year, he had the following income items  $1,000 of qualified dividends, $500 of interest income from a corporate bond, $200 from a municipal bond and $6,000 of net L/T capital gains. How much of investment interest expense can Frank claim on his return?  

Answer 1

Investment interest is interest paid on a loan where the proceeds were used to purchase property you held for investment. According to the Internal Revenue Service, "Property held for investment includes property that produces interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. It also includes property that produces gain or loss"

The amount of interest that can be deducted in any particular year is limited to a taxpayer's net investment income for that same year. It can't exceed that amount.

Taxpayers can elect to include qualified dividends and net capital gains in the calculation of net investment income for the year for the purpose of deducting investment interest. The effect of this election is that qualified dividends and net capital gains included in net investment income are taxed at ordinary tax rates, not at the lower long-term capital gains tax rates

Therefore, in this case, if Frank opts to include long term capital gain as an investment income, then the maximum investment interest expense that can be claimed is $ 3,500 (which is less than agreegate of all investment incomes). Else, if Franck opts not to include capital gains, then the maximum investment interest expense that can be claimed is restricted to $ 1,700 (sum of $ 1,000+ $200+ $700 is lower than $3,500).