If you borrow funds to make an investment-for instance, you may have received a "hot stock tip" from a broker-you generally have to pay interest on the loan. How much of this interest, if any, can you deduct on your tax return? The answer: It depends. To further complicate matters, a tax return decision may increase the amount you can deduct this year.

Basic premise: Only the interest attributable to investment purposes qualifies for the deduction. For instance, if you take out a loan to buy a new car for your graduating child, the resulting interest is nondeductible. It is purely a personal expense. If the loan is made partially for investment purposes and partially for personal reasons, you must make an allocation based on the appropriate percentage.

The qualified interest may be deducted only up to the amount of your net investment income. This is your investment income reduced by investment expenses other than interest. For purposes of this tax law limit, investment expenses are income-producing expenses that are allowable deductions after applying the 2% limit on aggregate miscellaneous itemized expenses. A few examples of these deductible expenses are certain fees for investment advisory services, safe deposit box rentals (for investments other than tax-exempt securities), etc.

Investment income includes such items as interest, dividends, royalties, gains from sales of investment property and income from annuities. However, net long-term capital gain and dividends qualifying for the preferential tax status generally do not count as investment income for purposes of the investment interest deduction, unless you make a special election.

How it works: You can choose to include long-term gain and low-taxed dividends in your net investment income computation, but you must reduce the gain eligible for the maximum long-term capital gain and qualified dividend tax rate by the same amount. Currently, the maximum tax rate for long-term capital gain and most domestic dividends is 15% for taxpayers with a regular income tax bracket higher than 15%.

For other taxpayers with a regular tax bracket of 10% or 15%, the preferential tax rate on long-term capital gain and qualified dividends is only 5% for 2007. Even better: This tax rate is scheduled to drop to 0% for 2008 through 2010.

Finally, other special tax rules, such as limits on passive activities, may also come into play when the computations are made. Do not make a hasty determination.

Bottom line: This is a complex decision that requires a careful analysis at tax return time. Consult with a tax professional with respect to your personal circumstances