Nondeductible Interest Expenses

Some interest expenses that you incur as an investor are not deductible.

Single-premium life insurance, endowment, and an- nuity contracts. You cannot deduct interest on money you borrow to buy or carry a single-premium life insurance, endowment, or annuity contract.

Used as collateral. If you use a single-premium annuity contract as collateral to obtain or continue a mortgage loan, you cannot deduct any interest on the loan that is collateralized by the annuity contract. Figure the amount of interest expense disallowed by multiplying the current interest rate on the mortgage loan by the lesser of the amount of the annuity contract used as collateral or the amount of the loan.

Borrowing on insurance. Generally, you cannot deduct interest on money you borrow to buy or carry a life insurance, endowment, or annuity contract if you plan to systematically borrow part or all of the increases in the cash value of the contract. This rule applies to the interest on the total amount borrowed to buy or carry the contract, not just the interest on the borrowed increases in the cash value.

Tax-exempt income. You cannot deduct interest expenses you incur to produce tax-exempt income, such as interest on money you borrow to buy tax-exempt securities or shares in a mutual fund or other regulated investment company that distributes only exempt-interest dividends.

Short-sale expenses. The rule disallowing a deduction for interest expenses on debt proceeds used to purchase tax-exempt securities applies to amounts you pay in connection with personal property used in a short sale or amounts paid by others for the use of any collateral in connection with the short sale. However, it does not apply to the expenses you incur if you deposit cash as collateral for the property used in the short sale and the cash does not earn a material return during the period of the sale. Short sales are discussed under Short Sales in chapter 4.

Expenses for both tax-exempt and taxable income. You may have expenses that are for both tax-exempt and taxable income. If you cannot specifically identify what part of the expenses is for each type of income, you can divide the expenses, using reasonable proportions based on facts and circumstances. You must attach a statement to your return showing how you divided the expenses and stating that each deduction claimed is not based on tax-exempt income.

One accepted method for dividing expenses is to do it in the same proportion that each type of income is to the total income. If the expenses relate in part to capital gains and losses, include the gains, but not the losses, in figuring this proportion. To find the part of the expenses that is for the tax-exempt income, divide your tax-exempt income by the total income and multiply your expenses by the result.

Example. You received $6,000 in interest income; $4,800 was tax exempt and $1,200 was taxable. In earning this income, you had $500 of expenses. You cannot specifically identify the amount of each expense item that is for each income item, so you must divide your

50 Chapter 3 Investment Expenses Publication 550 (2025)

expenses. 80% ($4,800 tax-exempt interest divided by $6,000 total interest) of your expenses is for the tax-exempt income. You cannot deduct $400 (80% of $500) of the expenses. You can deduct $100 (the rest of the expenses) because they are for the taxable interest.

State and local income taxes. If you itemize your deductions, you can deduct, as taxes, state and local income taxes on interest income that is exempt from federal income tax. But you cannot deduct state and local income taxes on other exempt income.

For tax year 2025, there is an overall limit of $40,000 ($20,000 if married filing separately) on the deduction for state and local taxes. You cannot deduct state and local income taxes to the extent that your total state and local tax deduction amount exceeds this limit. If your modified adjusted gross income is over $500,000 ($250,000 if married filing separately), your overall limit will be reduced, but will not be reduced below $10,000. See the 2025 Instructions for Schedule A (Form 1040) for more information.

Interest expense and carrying charges on straddles. You cannot deduct interest and carrying charges allocable to personal property that is part of a straddle. The nondeductible interest and carrying charges are added to the basis of the straddle property. However, this treatment does not apply if:

• All the offsetting positions making up the straddle either consist of one or more qualified covered call options and the optioned stock, or consist of section 1256 contracts (and the straddle is not part of a larger straddle); or

• The straddle is a hedging transaction.

For information about straddles, including definitions of the terms used in this discussion, see Straddles in chapter 4.

Interest includes any amount you pay or incur in connection with personal property used in a short sale. However, you must first apply the rules discussed under Pay- ments in lieu of dividends in chapter 4.

To determine the interest on market discount bonds and short-term obligations that are part of a straddle, you must first apply the rules discussed under Limit on interest deduction for market discount bonds and Limit on interest deduction for short-term obligations , earlier.

Nondeductible amount. Figure the nondeductible interest and carrying charges on straddle property as follows.

1. Add:

a. Interest on indebtedness incurred or continued to

buy or carry the personal property, and

b. All other amounts (including charges to insure,

store, or transport the personal property) paid or incurred to carry the personal property.

2. Subtract from the amount in (1):

a. Interest (including OID) includible in gross income

for the year on the personal property,

Basis adjustment. Add the nondeductible amount to the basis of your straddle property.