The world of investing is vast, exciting and often expensive for individual traders. Occasionally, you’ll encounter an investment opportunity you don’t want to pass up but can’t quite afford. Fortunately, you can borrow the funds necessary from your broker to acquire the asset and pay margin interest for the loan. Furthermore, you can deduct the cost of trading on margin from your taxes, allowing you to reduce your tax burden while trading assets you don’t have the financial capacity to purchase on your own. Here are the details on margin interest and how to deduct the costs from your taxes.
Consider working with a vetted financial advisor to discuss whether the investment makes sense for you and, if so, how you can deduct margin interest from your taxes.
What Is Margin Interest?
Margin interest is what an investor pays when borrowing money from their broker to purchase an asset. In other words, if you can’t afford an investment, you can take out a loan from your brokerage firm to purchase it.
Like taking out a loan from a traditional bank, the margin loan your broker gives accrues interest. As a result, trading on margin leads to interest payments, even if your investment doesn’t yield gains.
How to Calculate Margin Interest?
Interest rates among all kinds of industries fluctuate, and margin interest is no exception. The investment firm you use, the amount of money you borrow, and how quickly you sell an asset after purchasing will influence your interest rate.
To calculate the costs of margin interest, you’ll multiply your loan by your interest rate and divide the result by 360 (the number investment firms use for days in a year). Finally, you’ll multiply the result by the number of days you plan to hold the asset.
For example, say you borrow $20,000 to buy stock. Your brokerage firm charges you an effective interest rate of 7.5%, and you believe you’ll make the most profit by selling the stock after holding it for one week.
So, you calculate margin interest by first multiplying the loan amount by the interest rate:
$20,000 x 0.075 = $1,500
Then, divide the result by 360:
$1,500/360=$4.16, which is how much interest you accrue per day while the loan is in effect.
Finally, multiply the daily interest charge by the number of days you hold the asset:
$4.16×7 days = $29.12
Therefore, if you trade on margin and buy $20,000 of stock, you’ll pay $29.12 of margin interest when selling the stock one week later (seven days).
Is Margin Interest Tax Deductible?
Margin interest is tax deductible if you itemize your deductions. In addition, you can’t deduct more margin interest than your net investment income. Therefore, you must receive net income when combining taxable interest, dividend payments, and short-term capital gains to receive a tax deduction for margin interest paid in the same tax year.
In other words, you aren’t eligible to receive a deduction for margin interest if you take the standard deduction when filing taxes or pay $0 of margin interest in the tax year. You also aren’t eligible if you haven’t received any net investment income for the tax year.
Lastly, you can carry over margin interest to future tax years. As a result, past tax years of margin interest can create a tax deduction in the current tax year. Remember, you’ll need to itemize your deductions and have net investment income of greater than $0 to apply margin interest deductions.
Margin Interest Tax Deduction Caps
Your net investment income will cap your margin interest tax deduction for the current tax year. For example, say your investments gave you a net investment income of $1,000, and you have $5,000 of margin interest to deduct from your taxes. However, you can only deduct up to your net investment income for the year ($1,000). Therefore, you can deduct $1,000 of margin interest for this year’s taxes and carry over the remaining $4,000 to future years.
The Bottom Line
Margin interest is the cost of borrowing money from your broker to invest in stocks, bonds and other assets you can’t afford. You can deduct margin interest from your taxes by itemizing your deductions and subtracting margin interest costs from your net investment income.
Tax law limits how you can apply margin interest deductions. Specifically, you can never deduct more than your investments earn in any given tax year. However, any margin interest you don’t deduct from taxes can apply to future years. As a result, trading on margin can create a tax advantage and an opportunity to purchase a profitable asset you couldn’t otherwise afford.
Tips for Margin Interest Tax Deductions
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Source: finance.yahoo.com