If money is borrowed to purchase investments such as mutual funds, bonds, or stock, the taxpayer can usually deduct the interest pay on the loan. There are two limitations, however, on the amount of interest that can be deducted. First, a taxpayer cannot deduct the interest on loans used to buy investments that produce tax-exempt income. Second, the investment interest expense deduction for the year cannot exceed the net investment income for the year. Net investment income is the amount of your investment income over your investment expenses, other than investment interest expense. Investment income includes interest and short-term capital gains, but it does not include dividends that qualify for the special dividends tax rate.
Example: If you borrow money to buy a municipal bond, you cannot deduct the interest paid on the loan. The parents reduced their taxable income by $5,000 by deducting the interest paid on loans to purchase investments. Since the parents income was taxed at the 30% tax bracket, the income reduction may decrease their income taxes by $1,500 ($5,000 x 30%).
If you are in a combined (federal, self-employment, and state) tax bracket of 30%, you could reduce your taxes up to $300 for every $1,000 of income reduction by deducting the interest paid on loans used to purchase investments.