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Ambitious traders often leverage their investments, borrowing to increase the size of their positions if they believe they can earn a return that outpaces the interest rate on their loans. The practice of trading on margin is further incentivized by the tax code’s treatment of investment interest expenses. Even casual investors are eligible to deduct the interest they pay to trade on margins, providing a tax break. Some limits do apply to investment interest expense deductions.
For tax purposes, an investing individual may be considered an investor, a trader or a broker. Because brokers lend money to those who trade on margin, they’re not likely taking investment interest deductions. Whether you qualify as a trader or an investor changes how you report your investing expenses on your taxes. Traders are professionals who attempt to profit from short-term aberrations in market pricing, while investors aim to profit from buying and holding securities that appreciate in value.
Investors deduct their investment-related expenses, including margin interest, as part of their itemized deductions on Form 1040 Schedule A. Investment interest expense deductions cannot exceed the net investment income for the year, which includes taxable interest income and ordinary income dividends and capital gains. Any interest expense deduction that an investor can’t use in one year can reduce future years’ net investment income until entirely used up.
Federal tax laws exempt interest income from certain state and local bonds from federal taxation. Because the income is tax-exempt, taxpayers cannot deduct investment interest incurred to purchase these preferential municipal bonds. If a taxpayer could deduct the margin interest expense from borrowing the funds to purchase bonds that generate tax-exempt interest, he could borrow funds at a higher interest rate than the rate at which the bonds pay out and still generate positive cash-flow from the tax benefit.
Far fewer people will qualify for tax treatment as traders. In order to qualify, the taxpayer must buy and sell securities to take advantage of the short-term fluctuations in market behavior. There are additional tests on the frequency, regularity and size of trades, as well as examinations of other sources of income. Those who qualify as traders can deduct margin interest on Form 1040 Schedule C as a business expense. Unlike an investor’s margin interest, traders' interest deductions are not limited by the taxpayer’s net investment income for the year.
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