Investment Interest

If you borrow money that is used to acquire property you hold for investment, the interest you pay is investment interest.
You can deduct investment interest subject to the limit discussed later. However, you cannot deduct interest you
incurred to produce tax-exempt income. See Tax-exempt income, later, under Nondeductible Expenses. Nor can you
deduct interest expenses on straddles, also discussed under Nondeductible Expenses.

Investment interest does not include any qualified home mortgage interest or any interest taken into account in
computing income or loss from a passive activity.

Allocation of Interest Expense

If the money you borrowed is used for business or personal purposes as well as for investment, you must allocate the
debt among those purposes. Only the interest expense on the part of that debt used for investment purposes is treated as
investment interest. The allocation is not affected by the use of property that secures the debt. However, fully
deductible home mortgage interest is not treated as investment interest and the debt does not have to be allocated,
regardless of how the proceeds are used.

Example 1. You borrow $10,000 and use $8,000 to purchase stock. The other $2,000 is used to purchase items for your
home. Since 80% of the debt is used for, and allocated to, investment purposes, 80% of the interest on that debt is
investment interest. The other 20% is nondeductible personal interest.

When To Deduct Investment Interest

If you use the cash method of accounting, you must pay the interest before you can deduct it.

If you use an accrual method of accounting, you can deduct interest over the period it accrues, regardless of when you
pay it. For an exception, see Unpaid expenses owed to related party under When to Report Investment Expenses, later
in this chapter.

Example. You borrowed $1,000 on September 6, 1997, payable in 90 days at 12% interest. On December 5, 1997, you
paid this with a new note for $1,030, due on March 5, 1998. If you use the cash method of accounting, you cannot
deduct any portion of the $30 interest on your return for 1997 because you did not actually pay it. If you use an accrual
method, you may be able to deduct a portion of the interest on the loans through December 31, 1997, on your return for
1997.

Interest paid in advance. Generally, if you pay interest in advance for a period that goes beyond the end of the tax year,
you must spread the interest over the tax years to which it belongs. You can deduct in each year only the interest for that
year.

Interest on margin accounts. If you are a cash-basis taxpayer, you can deduct interest on margin accounts as investment
interest in the year you paid it. You are considered to have paid interest on these accounts only when you actually pay
the broker or when payment becomes available to the broker through your account. Payment may become available to
the broker through your account when the broker collects dividends or interest for your account, or sells securities held
for you or received from you.

Deferral of interest deduction for market discount bonds. The amount you can deduct for interest expense you paid or
accrued during the year to buy or carry a market discount bond may be limited. This limit applies if you do not accrue
the market discount and include it in your income currently.

Under this limit, the interest is deductible only to the extent it is more than:

1.The total interest and OID includible in gross income for the bond for the year, plus 2.The market discount for the
number of days you held the bond during the year.

Figure the amount in (2) above using the rules for figuring accrued market discount in chapter 1 under Market Discount
Bonds.

Disallowed interest expense. In the year you dispose of the bond, you can deduct the amount of any interest expense you
were not allowed to deduct for an earlier year.

Choosing to deduct disallowed interest expense before the year of disposition. You can choose to deduct disallowed
interest expense in any year before the year you dispose of the bond, up to your net interest income from the bond during
the year. The balance of the disallowed interest expense remains deductible in the year you dispose of the bond.

Net interest income. This is the interest income (including OID) from the bond that you include in income for the year,
minus the interest expense paid or accrued during the year to purchase or carry the bond.

Deferral of interest deduction for short-term obligations. If the current income inclusion rules discussed in chapter 1
under Discount on Short-Term Obligations do not apply to you, the amount you can deduct for interest expense you paid
or accrued during the year to purchase or carry a short-term obligation is limited.

The interest is deductible only to the extent it is more than:

1.The amount of acquisition discount or OID on the obligation for the tax year, plus 2.The amount of any interest
payable on the obligation for the year that is not included in income because of your accounting method (other than
interest taken into account in determining the amount of acquisition discount or OID).

The method of determining acquisition discount and OID for short-term obligations is discussed in chapter 1 under
Discount on Short-Term Obligations.

Disallowed interest expense. In the year you dispose of the obligation, or if you choose, in another year in which you
have net interest income from the obligation, you can deduct the amount of any interest expense you were not allowed to
deduct for an earlier year. Follow the same rules provided in the earlier discussion under Deferral of interest deduction
for market discount bonds.

Limit on Investment Interest

The amount of investment interest you can deduct is limited. This limit applies to interest paid or accrued in 1997 on
money that you borrowed that is properly allocable to investment property. It also applies to any disallowed investment
interest carried over from 1996.

Form 4952. Use Form 4952, Investment Interest Expense Deduction, to figure your total deduction for investment
interest. However, you do not have to complete Form 4952 or attach it to your return if all of the following apply.

Your only investment income was from interest or dividends. òYou do not have any other deductible expenses directly
connected with the production of that income. òYour investment interest expense is not more than the total of that
income. You have no carryover of investment interest expense from 1996.

Investment interest. Investment interest generally is the interest you paid or accrued on money you borrowed that is
properly allocable to property held for investment.

Investment property. 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
(not derived in the ordinary course of a trade or business) from the sale or trade of property producing these types of
income or held for investment (other than an interest in a passive activity). Investment property also includes an interest
in a trade or business activity in which you did not materially participate (other than a passive activity).