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Protect your deductions for margin-loan interest

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in Small Business Tax

When you buy securities “on margin,” you use money that’s borrowed from your broker and pay interest rates pegged to the broker’s call rate. So, if you pay 8 percent to buy stocks and the stocks return 10 percent, you’re ahead of the game.

Advice: Consider the after-tax impact of margin loans. If you can deduct the interest, you’ll reduce the net cost of an 8 percent loan to a little more than 5 percent (for someone in the 35 percent tax bracket).

Here are three ways to ensure that margin loans are deductible:

1. Use margin loans for securities: To qualify for deductions, you must use the proceeds of a margin loan solely to buy securities or investment property. So, if you use the cash to buy a car, pay your child’s college tuition, etc., the interest qualifies as nondeductible personal interest. The simplest way to handle matters is to use margin loans for securities.

2. Soak up investment interest: Even if you use the loan proceeds properly, you may deduct investment interest only up to the amount of your net investment income for the year. Therefore, you need to generate enough investment income to absorb the margin-loan interest.

For this purpose, investment income includes interest, short-term capital gains and, if necessary, long-term capital gains and dividends. You can carry any excess investment interest forward to next year.

Note: If you count long-term capital gains or dividends as investment income, you forfeit the benefit of the reduced 15 percent federal income-tax rate.

So, if your portfolio is weighted heavily toward stocks, you may not have enough interest income to soak up the margin interest you’d like to deduct. Try shifting some of your assets into securities that pay out current dividends or interest.

3. Avoid tax-exempt bonds: Yet another tax problem may arise: You can’t deduct margin-loan interest if the proceeds are used to “purchase or carry” tax-exempt munis or bond funds.

Example: If municipal bonds represent 20 percent of the assets in your brokerage account, you can write off no more than 80 percent of your investment interest. Keeping munis in a separate account may help, but the IRS might contend that the loans help “carry” the bonds.

Tip: You must report tax-exempt interest on your return, so it’s easy for the IRS to match up this income with deductions for investment interest that you paid.

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