There’s a cap on deductibility equal to your net investment income, but any leftover interest expense can be carried over for future use, without expiration.

To calculate your net investment income—and therefore how much investment interest expense you can deduct—add up your taxable interest income, ordinary dividends and even long-term capital gains and qualified dividends (if you make a special election to treat them as ordinary income, more below). Then, subtract any investment-related miscellaneous itemized deductions you actually get to use.

For example: Say you have $10,000 of investment interest expense, $10,000 of taxable investment income and $5,000 of investment-related miscellaneous itemized deductions—$1,000 of which you can use given your AGI. Your net investment income is $9,000 ($10,000 in investment income minus $1,000 in allowable investment-related miscellaneous itemized deductions). You could deduct a matching amount of investment interest expense: $9,000.

The remaining $1,000 of unused investment interest expense could be carried forward for potential use in future years.

How do the qualified dividend rules impact investment interest expense?

• Qualified dividends. Qualified dividends that receive preferential tax treatment aren’t considered investment income for purposes of the investment interest expense deduction.1 However, you could elect to treat qualified dividends as ordinary income (just as you can with net long-term capital gain income) to boost the amount you can deduct as investment interest expense. The concept here is that it’s better to pay 0% tax on qualified dividends than 15% or 20% tax.
Let’s go back to our example: If you also have $1,000 of qualified dividends, you could pay 15% (or 20%) tax on them, or you could elect to treat those dividends as ordinary income and boost your net investment income from $9,000 to $10,000—which means you could now deduct up to $10,000 in investment interest expense in the current year.

• Payment in lieu of dividends. If you buy dividend-paying stock on margin and your broker lends out the stock, you don’t really receive dividends; you receive payment in lieu of dividends. These payments are treated as ordinary income and aren’t eligible for the qualified dividend rate. But all is not lost: The payments are eligible to offset your investment interest expense.
However, if you already have sufficient ordinary investment income from other sources (or more payment in lieu of dividends than can be used), you’re stuck with ordinary tax treatment.

Capital losses
Capital losses can be used to offset capital gains without limit in any given year. If your capital losses exceed your capital gains, up to $3,000 in losses (or $1,500 each for married filing separately) could be used to offset ordinary income. Net losses of more than $3,000 can be carried forward to offset gains in the future.

Reminder on cost basis reporting rules
Since 2011, financial institutions have been required to report to the IRS the adjusted cost basis of sold securities acquired after a certain date, including:

• Equities acquired on or after January 1, 2011.
• Mutual funds, exchange-traded funds and dividend reinvestment plans acquired on or after January 1, 2012.
Other specified securities, including most fixed income securities and options acquired on or after January 1, 2014.