Can You Deduct Interest on Loans to Purchase Stock?
The deductibility of interest expense is a complicated area of tax law because of an ongoing conflict between the Internal Revenue Service (IRS) and taxpayers. As interest represents the ongoing actual cost to borrow money, the taxpayer wants to deduct 100% of this expense. However, the IRS in its role of maximizing tax revenues wants to limit the amount of interest expense you can deduct on your tax return.
One facet of this contentious issue is the deductibility of interest on loans used to purchase corporate stock.
There does not seem to be any conflict when it comes to the purchase of C-corporation stock. The rules under §1.163-8T(a)(3) require tracing of the loan proceeds to their ultimate use and this use determines the treatment of the resulting interest expense. The purchase of C-corporation stock is considered an investment, so any loan interest to purchase this type of stock is considered investment interest which is subject to many rules and limitations on deductibility.
The purchase of S-corporation stock is another matter. Because of the pass-through nature of S-corporation income and expenses the IRS has special rules to determine the deductibility of interest on loans to purchase S-corporation stock. The IRS requires the borrower to look at the assets of the S-corporation they purchased stock in to determine if those assets are used in a trade or business, investments, passive activities, etc. The borrower can then allocate the proceeds from the loan in any reasonable manner to determine how they treat the interest from the loan used to purchase the S-corporation stock. In this way, if a portion of the S-corporation assets are related to an active trade or business, then a portion of the interest is reported on the borrower’s Schedule E on their 1040 and deducted against the S-corporation’s other trade or business income. The remainder of the interest would be reported as allocated by the taxpayer (investment interest, passive activity interest, etc.).
So the short answer is you can deduct interest on loans used to purchase stock- but how you report it and where it ends up on your personal tax return is a complex matter. Since this is a complicated and contentious area of tax law please consult your tax advisor if you think this issue applies to your tax situation.