Where Did the Money Go?

It doesn't matter what, if anything, you use for collateral in order to get the loan. What the IRS is looking at is how you spent the money. If you spent the money on property that produces dividends, interest, annuities, royalties, or gains or losses, and it is not a trade or business or a passive activity, it will be considered "investment interest" that is potentially deductible.

However, you can't deduct interest on loans taken out to purchase tax-exempt investments, such as municipal bonds; on loans taken out to purchase single-premium life insurance, annuity, or endowment contracts; or on loans to purchase certain types of straddles.

Since the IRS is interested in where the money went, you need to be sure that you have a paper trail, including deposit slips, canceled checks, or account statements (and preferably all three) so that you can prove you actually spent the money on investment property. If you took out a loan and deposited the proceeds in your bank account (for example, while you investigated a number of investment opportunities), any interest you pay is considered "investment interest" unless and until you spend the money on personal items.

We mentioned that interest related to passive activities is not considered "investment" interest. This may seem strange, considering that most people think of passive activities as precisely that - investments, rather than actively conducted businesses. However, the IRS draws another distinction between (a) passive activities, losses (and deductions) which can only be offset by income from other passive activities, and (b) portfolio or investment assets. For that reason, you may deduct passive activity interest from passive activity income, and investment interest from investment income - the lines may never cross. See our discussion of passive activities for more on the definition of what is or isn't considered passive.