If you borrow money from your broker to buy stocks, you're trading on margin. Brokers will charge interest on the loan, but since the stocks serve as collateral, the interest rate on this secured debt will be reasonably low. In addition, the IRS allows you to deduct the interest, with the deductible amount limited to your net investment income.
Taxable Income and Deductions
The IRS allows deductions for business-related expenses, and since trading stocks is -- hopefully -- a business activity that produces taxable income, the costs of doing so are deductible. An important caveat is that the income must be taxable -- you may not deduct interest paid to buy tax-exempt securities, such as municipal bonds.
Limits on Interest Deduction
The IRS limits the interest deduction to the amount of net investment income. If you earn $10,000 from capital gains on your trades, in addition to interest income and ordinary dividends, then you can only deduct $10,000 in margin interest paid. You don't add in "qualified" dividends, certain payouts which qualify for long-term capital gains rates. In addition to margin interest, you can deduct brokerage commissions by adding them to your cost basis. When you sell the stock, commissions are subtracted from your proceeds.
If you have investment income, you can subtract all investment-related expenses which you use to adjust your gross income. For example, a fee charged by your broker for account management would come off your gross income. It can also be used to adjust your investment income, for the purpose of calculating the margin-interest deduction. For example, if you have $10,000 of investment income and a $250 account management fee, you can take the $250 fee as an itemized deduction, and also deduct a maximum of $9,750 of investment interest paid.
If you reach the limit on the margin interest deduction, you may carry the remaining amount forward to the following year. The limit remains, however -- the amount of your net investment income in the year you claim the deduction. Margin interest is deducted on Line 14 of Schedule A, used for itemized deductions. If you take the standard deduction and don't itemize, then you can't take the deduction for investment interest.
Founder/president of the innovative reference publisher The Archive LLC, Tom Streissguth has been a self-employed business owner, independent bookseller and freelance author in the school/library market. Holding a bachelor's degree from Yale, Streissguth has published more than 100 works of history, biography, current affairs and geography for young readers.