Investment Interest
This is the interest you pay on loans, including your margin account, used to finance taxable investments. In general, investment interest is deductible if used to purchase taxable investments, and then only to the extent of your net investment income. Any investment interest that is not currently deductible can be carried forward indefinitely. In any case, no deduction is allowed for interest paid on indebtedness incurred to purchase or carry tax-exempt securities. Deductions for investment expenses are not subject to either the 2% floor for miscellaneous itemized deductions or the phase-out for high-income taxpayers. Keep in mind that the IRS has sophisticated tracing rules in instances where taxpayers hold tax-exempt securities.
Net investment income is your investment income minus your investment expenses. Investment income is defined as the sum of interest, dividends, royalties, and net short-term capital gains, but excludes net long-term capital gains. You can elect to include as much of your net long-term capital gains in investment income as you choose if you also reduce the amount of net long-term capital gains eligible for the capital gains rate by the same amount. Investment expenses are those that are directly related to the production of investment income, such as those incurred for investment advice.
Although excess investment interest expense may be carried forward, realizing short-term capital gains to offset excess investment interest effectively creates a current tax-free source of income.
Home Mortgage Interest
The deduction for home mortgage interest depends on whether it qualifies as acquisition indebtedness or home equity indebtedness.
- Acquisition indebtedness is debt incurred in acquiring, constructing, or substantially improving a principal or second residence. The loan must be secured by the residence. Mortgage interest is deductible on acquisition indebtedness of up to $1 million (one-half million dollars for married taxpayers filing separately).
- Home equity indebtedness is debt secured by your principal or second residence and does not exceed the fair market value of the residence minus the acquisition indebtedness. Mortgage interest is deductible on home equity indebtedness of up to $100,000.
Education Loan Interest
This is debt incurred on any qualified higher-education loan. Eligible students may deduct interest paid on qualified higher-education loans. The maximum amount of deductible interest is $2,500. For 2012, phase-out begins for modified adjusted gross income levels of $60,000 for singles and $125,000 for married filing jointly. The deduction for interest on qualified education loans is an "above-the-line" deduction that is allowed whether or not you itemize your other deductions.
Consumer Interest
This is defined as any interest that is not mortgage, investment, education, trade, or business related. It includes interest on loans to purchase consumer goods and interest on credit card balances. Consumer interest is not deductible.
Taxpayers are required to trace the use of proceeds on non-mortgage debt to determine its deductibility. You should develop a tax-wise borrowing strategy, focusing on proper planning and record keeping. Within the limitations on mortgage interest described earlier, home equity borrowing should be considered whenever possible. For example, you may take out a home equity loan and use the proceeds to pay off consumer debt. If the loan is less than $100,000, the interest is generally fully deductible. (Be sure to keep in mind that there may be additional transaction costs and a longer loan period associated with the specific financing option you choose.)