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I have $5,000 of interest income, $5,000 of mortgage interest, another $5,000 of capital losses, and claim the standard deduction. What is the most reliable way to cancel out the interest income for tax purposes?

For example:

  • Is it legal to have a business entity that merely arbitrages interest rates, so that I put the interest income on schedule C rather than on 1040 line 2 taxable interest? (and then deduct the interest expense, or even the cost of the computer I'm typing on?)

  • What if I earn the interest using a combination of options or futures. Can I then deduct capital losses? (Or will the IRS "impute interest" the way it does for T-bills?)

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    The capital losses will be reported on schedule D. They are used to offset capital gains first, then you can take $3000/year of losses to offset ordinary income. The rest is carried forward to next year. This group of things would result in $2000 of ordinary income and $2000 of capital loss carryforward if you take the standard deduction. Commented Mar 30, 2023 at 1:58
  • If you get the interest from bonds issued by state and local government agencies -- traditionally though imprecisely called 'municipal' or 'muni' bonds -- directly or through a mutual fund or ETF, that interest is exempt from federal tax; you don't have to cancel it because it isn't included at all (but is reported on line 2a). Muni interest from your own state is also exempt from state tax in states that have income tax. Commented Mar 31, 2023 at 6:26

2 Answers 2

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Interest income is regular taxable income. There's no concept of "canceling out". You report it on Schedule B and line 2 form 1040.

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  • I see: "interest" is, by definition, taxed on 1040 line 2 and we can't deduct from that. This appears to be an accurate answer. I would add that guaranteed returns at the risk-free interest rate are not always classified as interest and therefore deductions are possible in some cases -- but we don't refer to those cases as "interest". Commented Mar 29, 2023 at 19:09
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    @personal_cloud -- you don't deduct from individual income streams; you have income (salary, interest, dividends, capital gains, etc.) and you have deductions (mortgage interest, capital losses, investment expenses, etc.). The tax you owe is based on income minus deductions, regardless of where they come from or how they might be interconnected. Commented Mar 31, 2023 at 13:09
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Businesses can claim all sorts of tax deductions that are not available to individuals. But you can't just declare that something is a business expense and try to deduct it when it is really a personal expense. Your home mortgage is not a business expense.

If you have a home office, you may be able to deduct a percentage of your mortgage as a business expense, the percentage that can reasonably be allocated to the office. But certainly not the entire mortgage. And if you don't really have a home office, you can't just pretend that you do.

Trying to classify a personal expense as a business expense is a very common trick that the IRS is on to. I wouldn't try it.

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    Note that "reasonably" for a home office is taken to mean that you are claiming exactly and only the space used for nothing but that business. A computer in the guest room doesn't let you claim the entire guest room, though you can probably claim the space immediately surrounding the desk. I actually had an entire room with nothing but the desks, bookshelves of work-related material, and the like, so I could probably have claimed it, but didn't because I wanted to use the same space for personal work.
    – keshlam
    Commented Mar 31, 2023 at 13:06
  • This is not really related to the question though. The OP says they have interest income and interest expense and are asking if they can just cancel them out, and they can't. Deductions available to businesses are also available to individuals, but only to the extent they have business income.
    – littleadv
    Commented Mar 31, 2023 at 16:33
  • @littleadv I'd think that if you have business income, you by definition have a business. I'm not sure what it would mean to say, "I made $X by selling products and services to retail customers, but I don't have a business."
    – Jay
    Commented Apr 1, 2023 at 1:23
  • @Jay but... the OP isn't saying that. I'm not sure I understand how your answer is related to the question.,
    – littleadv
    Commented Apr 1, 2023 at 1:31
  • @littleadv I didn't say that the OP said that. You said that. In your post just before mine. Anyway, I don't want to argue about it, so feel free to get the last word.
    – Jay
    Commented Apr 1, 2023 at 1:44

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