Generally, the Internal Revenue Service (IRS) allows you to deduct the interest on loans you incur for the purpose of generating taxable income or for investments that would be taxable, if they generated current income from dividends. In most cases, interest on margin loans qualifies under this rule. There are, however, certain exceptions.
Many brokers allow their clients to borrow money from the brokerage company, using the securities in their accounts as collateral for the loan. The proceeds from a margin loan can be used for any purpose. You will have to pay the brokerage an interest rate on the loan. If the securities in your account decline in value, you may receive a "margin call" to pay off all or a portion of the loan, or add more cash to your account. Otherwise, the brokerage may sell your positions in your account to pay off the loan, possibly leaving you with a significant capital gains tax liability.
Taxation of Margin Loans
Cash you receive from margin borrowing is not taxable, since the IRS considers it borrowed money, and not income. The interest you pay, however, is tax deductible if you use the proceeds of the loan for investment purposes, rather than for your own personal reasons. For example, you can deduct the interest on a margin loan to buy inventory for a business, or to buy securities, but you cannot deduct the interest on a loan you use to buy a car for your own personal use. Note that you cannot deduct interest on loans you use to buy municipal bonds. The interest on these bonds is generally free of federal income tax.
Mixed Purpose Loans
If you use the proceeds of a margin loan to buy a mixed-use property -- that is, property that is partially for business purposes, and partially for your own personal use, you must prorate the interest. If the property is to be used 50 percent for business and 50 percent for your own use, then you can deduct up to 50 percent of the loan interest.
Normally, the interest on home mortgages of up to $1 million, and on personal home improvement loans of up to $100,000 are tax deductible. However, to qualify for this favorable tax treatment, the IRS requires that the loan be secured by the properties it purchased. Therefore, you cannot deduct interest on margin loans for these purposes, though you can deduct the interest to the extent the properties were investment properties rather than personal property.
To deduct margin interest, you must actually pay the interest during the tax year. You cannot deduct margin interest if you are letting the interest accrue. You also can only deduct interest expense on money borrowed to buy securities or investment property to the extent you have interest income.
Leslie McClintock has been writing professionally since 2001. She has been published in "Wealth and Retirement Planner," "Senior Market Advisor," "The Annuity Selling Guide," and many other outlets. A licensed life and health insurance agent, McClintock holds a B.A. from the University of Southern California.