If a taxpayer borrows money to purchase investments, such as mutual funds, bonds or stock, the interest paid on the loan can usually be deducted. There are two limitations, however, on the amount of interest that can be deducted. First, a taxpayer cannot deduct the interest on loans used to buy investments that produce tax-exempt income. In other words, if a taxpayer borrows money to buy a municipal bond, the interest paid on the loan cannot be deducted.
Second, a taxpayer’s investment interest expense deduction for the year cannot exceed the net investment income for the year. Net investment income is the amount of a taxpayer’s investment income over his or her investment expenses, other than investment interest expense, for the year. Investment income includes interest and short-term capital gains, however it does not include dividends that qualify for the special dividends tax rate. Investment expenses include amounts paid for investment advice, investment publications and safe deposit boxes. Investment expenses do not include brokers’ fees taxpayers pay when buying or selling stock. These are added to the cost of the stock and reduce the gain or increase the loss when the stock is sold.
If part of the interest a taxpayer pays is not deductible because it exceeds the investment income, the disallowed deduction is not lost. The amount can be carried forward to future years. The disallowed amount is then deducted in the year or years that the taxpayer’s net investment income exceeds his or her investment interest.
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EXAMPLE If your client has $2,000 of net investment income and $2,400 of investment interest expense, you can deduct $2,000 of investment interest. The $400 ($2,400 – 2,000) you could not deduct is carried forward to the following year. |
Investment Expenses
In calculating net investment income, investment income is reduced only by the investment expenses you can deduct. If you cannot deduct investment expenses because of the 2% of adjusted gross income (AGI) floor for miscellaneous deductions, you do not need to reduce investment income by the expenses. In other words, the investment income is reduced only by expenses from which a taxpayer receives a tax benefit.
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EXAMPLE Because miscellaneous expenses must exceed 2% of your client’s AGI, $1,000 ($50,000 x 2%), before he or she can take a deduction for the expenses, you cannot deduct the investment expenses. As a result, you do not have to reduce the investment income by the investment expenses. The net investment income is $1,800, so you can deduct the entire $1,700 of investment interest expense. |
Qualifying Dividends and Long-Term Capital Gains
Qualifying dividends and long-term capital gains, including capital gain distributions from mutual funds, are not automatically included in investment income. You may elect to include qualifying dividends and long-term capital gains in the calculation of the net investment income. You may elect to include qualifying dividends and long-term capital gains in the calculation of the net investment income. If the election is made, qualifying dividends and long-term capital gains are taxed as they are ordinary income. In other words, the maximum 15% rate on qualifying dividends and long-term capital gains must be sacrificed to generate an investment interest expense deduction at ordinary rates.
Congress changed the law to prevent taxpayers from taking advantage of the difference in rates between ordinary income and long-term capital gains. Without the change, taxpayers could deduct interest expense at his or her ordinary tax rate of 25%, 28%, 33% and 35%. At the same time, taxpayers could have your qualifying dividends and long-term capital gains taxed at a 15% tax rate.
For the most part, planning with this election is straightforward. If the net investment income is more than the investment interest expense without including qualifying dividends and long-term capital gains, do not make the election to include long-term capital gains in investment income. This way the taxpayer benefits from the 15% maximum tax rate on the qualifying dividends and capital gains.
The difficult choice occurs when qualifying dividends and long-term capital gains are taxed at a rate lower than an ordinary tax rate. If a taxpayer’s investment interest expense deduction is limited because he or she does not have enough investment income, the taxpayer must choose between an investment interest expense deduction today or an investment interest expense deduction in a future year. The decision depends on the amount of qualifying dividends and long-term capital gain that will be taxed at the ordinary tax rate if the election is made; and the amount of interest deduction that will be lost this year and carry over to the next if the election is not made. The decision also depends on how much investment income is expected in the future.
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EXAMPLE Your client is in the 33% tax rate bracket, has an investment income of $2,000 and a long-term capital gain of $3,000. Itemized deductions include investment interest expense of $2,700. If no election is made, your client will pay tax of $450 (15% x $3,000) on the long-term capital gain. There is no tax on the net investment income of $2,000 because it is offset by $2,000 of the investment interest expense. Your client has an investment interest expense. There is an investment interest expense carry-over of $700 ($2,700 – 2,000). The $700 carry-over could reduce tax by $231 ($700 x 33%) in the following year if there is enough investment income. If you make the election to tax $700 of the $3,000 long-term capital gain at ordinary rates, all of the investment interest expense is deductible in the current year. Your client pays tax of $345 (($2,000 + 700 – 2,700) x 33%) + (15% x 2,300 (the remaining long-term capital gain)) on the income. Your client saves $105 ($450 – 345) this year, but no longer has an investment interest expense carry-over. Thus, over the two-year period, your client may pay additional tax of $126 ($231 (savings by not making the election and using the investment interest carry-over next year)). If you are certain your client’s investment income next year will be more than his or her investment interest expense and investment interest expense carry-over, you should not make the election. By making the election, you can deduct the investment interest expense this year when you know your client can take the deduction. |
Julie Welch (Runtz) is the Owner of Meara Welch Browne, P.C. She graduated from William Jewell College with a BS in Accounting and obtained a Masters in Taxation from the University of Missouri-Kansas City. She serves as a discussion leader for the AICPA National Tax Education Program. She is co-author of 101 Tax Saving Ideas.
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