Investment Expenses: What's Tax Deductible?

December 6, 2022 Hayden Adams
The IRS allows taxpayers various tax deductions for investment-related expenses if those expenses are related to producing taxable investment income. Do your expenses qualify?

The IRS allows various tax deductions for investment-related expenses if those expenses are related to producing taxable investment income.

Since maximizing your tax deductions has the potential to reduce your tax burden, let's look at some of the most common deductible investment expenses and how they can reduce your taxable income.

No more deduction for miscellaneous investment-related expenses

For tax years 2018 to 2025, "miscellaneous itemized deductions" have been eliminated. Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), taxpayers were allowed to deduct expenses such as fees for investment advice, IRA custodial fees, and accounting costs necessary to produce or collect taxable income. 

Investment interest expense

If you itemize, you may be able to claim a deduction for your investment interest expenses—the interest paid on money borrowed to purchase taxable investments. This includes the interest on margin loans used to buy stock in your brokerage account and the interest on loans used to buy investment property. (This wouldn't apply if you used the loan to buy tax-advantaged investments such as municipal bonds.)

The amount that you can deduct is capped at your net taxable investment income for the year. Any leftover interest expense gets carried forward to the next year and potentially can be used to reduce taxes in the future. 

To determine your deductible investment interest expense, you need to know the following:

  • Your total investment income for investments taxed at your ordinary income rate 
  • Your total investment interest expenses (for loans used to purchase taxable investments)

To calculate your deductible investment interest expense, you first need to determine your net investment income. This normally includes ordinary dividends, which are taxed at ordinary income tax rates, and interest income. It does not include investment income taxed at the lower, long-term capital gains tax rates, or municipal bond interest, which is not taxed at all.

Now, compare your net investment income to your investment interest expenses. If your investment interest expenses are less than your net investment income, the entire investment interest expense is deductible. If the investment interest expenses are more than the net investment income, you can deduct the expenses up to the net investment income amount. The rest of the expenses are carried forward to next year.

An example will probably make this easier to understand. Let's say Mary has $150,000 of total income, $8,000 of investment income (from ordinary dividends and interest income), $10,500 of investment interest expenses from a margin loan, and $13,000 of other itemized deductions (such as mortgage interest and state taxes).

In this example, Mary has $8,000 in net investment income and $10,500 in investment interest expenses. She is allowed to deduct the smaller of the two amounts. Thus she is able to reduce her taxable income by $8,000 with an additional $13,000 in itemized deductions.

*Example assumes that Mary itemizes deductions.
The example is hypothetical and provided for illustrative purposes only.

Because of the investment interest expense deduction and other itemized deductions, Mary's taxable income has been reduced from $150,000 to $129,000.

Qualified dividends

Qualified dividends that receive preferential tax treatment aren't considered investment income for purposes of the investment interest expense deduction. However, you can opt to have your qualified dividends treated as ordinary income.

In the right circumstances, electing to treat qualified dividends as ordinary dividends can increase your investment interest expense deduction, which could allow you to pay 0% tax on the dividends instead of the 15% or 20% tax that qualified dividends normally receive. Here's an example of how it might work.

In addition to the information in the first example, let's say Mary has $2,000 of qualified dividends, on which she would normally pay $300 in tax ($2,000 x 15% long term capital gains tax rate). If Mary elected instead to treat the qualified dividends as ordinary income, she could boost her net investment income from $8,000 to $10,000. As a result, she would be able to deduct more of her investment interest expense in the current year—and pay no tax on the qualified dividends.

In this example, Mary has an additional $2,000 in qualified dividend income. This brings her total investment income up to $10,000. This is still less than her investment interest expenses. Thus, she can deduct $10,000 from her taxable income with an additional $13,000 in itemized deductions.

*Example assumes that Mary itemizes deductions.
The example is hypothetical and provided for illustrative purposes only.

Because Mary is a tax-savvy investor, she was able to reduce her taxable income from the original $150,000 to $127,000. That $10,000 investment interest expenses deduction resulted in $2,220 of tax savings (assuming an ordinary tax rate of 24% and a long-term capital gains tax rate of 15%).

Note: The election to treat qualified dividends as ordinary dividends should not be taken lightly. Once made, the election can only be revoked with IRS consent. Consult with your tax professional before implementing this tax strategy.

Capital losses

Losing money is never fun, but there is a silver lining. Capital losses can be used to offset your capital gains. If your capital losses exceed your capital gains, up to $3,000 of those losses (or $1,500 each for married filing separately) can be used to offset ordinary income and lower your tax bill. Net losses of more than $3,000 can be carried forward to offset gains in future tax years.

Don't forget about the cost basis of your investment

To make the most effective use of capital losses, keep track of your investment cost basis. The cost basis is generally equal to an investment's purchase price plus any expenses necessary to acquire that asset, such as commissions and transaction fees. 

When you sell your investment, the cost basis is used to reduce the taxable gain.

Where to get help

The IRS also has some resources that provide examples and detailed explanations of the topics included in this article, including: Publication 550, Publication 529, and the instructions for Form 1040, Schedule A, Schedule D, and Form 4952

In addition, be sure to consult your tax professional (CPA, lawyer, or enrolled agent) about your situation, preferably well before the end of the year. No matter the time of year, it's also a good idea to check with your tax advisor before you enter into any transaction that might have significant tax consequences.

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

The type of securities and accounts mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.

This information does not constitute and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.