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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 3, 2006, payable in 90 days at 12% interest. On December 2, 2006, you paid this with a new note for $1,030, due on March 2, 2007. If you use the cash method of accounting, you cannot deduct any part of the $30 interest on your return for 2006 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, 2006, on your return for 2006.

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 under the OID rules. You can deduct in each year only the interest for that year.

Interest on margin accounts:
If you are a cash method taxpayer, you can deduct interest on margin accounts to buy taxable securities 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.

You cannot deduct any interest on money borrowed for personal reasons.

Limit on 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 does not apply if you 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:

• The total interest and OID includible in gross income for the bond for the year, plus
• 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.

Back to: Investment Interest Expense Index

Other sections to read about investment interest expense: Investment Interest Expense, Investment Interest General Information, Allocation of Interest Expense, When to Deduct Interest Expense, Form 4954 Guidelines, Investment Income of Children, Limits on Investment Interest Deduction, Investment Expenses