As part of ThinkAdvisor’s Special Report, 23 Days of Tax Planning Advice: 2016, throughout the month of March, we are partnering with our ALM sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.
1. What is investment income for purposes of the investment interest deduction?
“Net investment income” is investment income reduced by the deductible expenses–other than interest–that are directly connected with its production. For purposes of this calculation, the 2 percent floor on miscellaneous itemized deductions is applied before investment income is reduced by investment expenses; thus, only those investment expenses that are allowable as a deduction after application of the 2 percent floor operate to reduce investment income.
“Investment income” means the sum of: (1) gross income from property held for investment (other than net gain attributable to dispositions of such property); (2) the excess, if any, of (i) “net gain” attributable to the disposition of property held for investment over (ii) the “net capital gain” determined by taking into account gains and losses from dispositions of property held for investment; and (3) any net capital gain (or, if less, the net gain amount described in (2)), with respect to which a special election is made (see below). In other words, investment income, for purposes of computing the investment interest deduction, generally does not include net capital gain from the disposition of investment property, unless the election described below is made.
Special elections are available that allow taxpayers to elect in any year to include all or a portion of net capital gain or qualified dividend income attributable to dispositions of property held for investment, as investment income. If the elections are made, any net capital gain or qualified dividend income treated as investment income will be subject to the taxpayer’s ordinary income tax rates. The advantage of making the elections is that a taxpayer may increase the amount of his investment income against which investment interest is deducted, thus receiving the full benefit of the deduction.
The elections for net capital gain and qualified dividend income must be made on or before the due date (including extensions) of the income tax return for the taxable year in which the net capital gain is recognized, or the qualified dividend income is received, respectively. The elections are made on Form 4952, “Investment Interest Expense Deduction” and may not be revoked for that year, except with IRS permission. However, making the election in one year does not bind the taxpayer for any other year.
The IRS has determined that capital loss carryovers that reduce taxable gain for income tax purposes in the year to which carried as a result of the election should also reduce investment income to the same extent for purposes of the investment expense limitation.
2. Is interest on amounts borrowed in order to make or hold taxable investments deductible?
Yes, within limits. The Code permits a deduction for interest paid in the year on indebtedness properly allocable to property held for investment (investment interest).However, there is a limit on otherwise allowable deductions that may be taken by an individual investor for investment interest. (Interest not deductible for some other reason, such as interest on indebtedness to purchase or carry tax-exempt obligations, is not taken into consideration in determining the amount subject to this limit.) Deductible short sale expenses are treated as interest subject to the limit.
Generally, the investment interest deduction is limited to the amount of an investor’s net investment income. Any other investment interest expense is considered excess investment interest and is disallowed.
Investment interest expense disallowed because of the investment income limitation will be treated as investment interest paid or accrued in the succeeding tax year. The IRS will not limit the carryover of a taxpayer’s disallowed investment interest to a succeeding taxable year to the taxpayer’s taxable income for the taxable year in which the interest is paid or accrued.
Investment interest expense and investment income and expenses do not include items from a trade or business in which the taxpayer materially participates. The IRS has determined that interest on a loan incurred to purchase stock in a C corporation was investment interest (where the purchaser was not a dealer or trader in stock or securities), even though the purchaser acquired the stock to protect his employment with the C corporation.
Future regulations should clarify the treatment of interest on a debt incurred to purchase a partnership or S corporation interest. IRS guidance generally requires that such interest expense be allocated among all the assets of the entity using any reasonable method. Regulations will also clarify the treatment of interest on debt of passthrough entities allocated to distributions to the owners of the entity. If the debt of a passthrough entity is allocable under the interest tracing rules to distributions to owners of the entity, then the interest tracing rules will govern allocation of the owner’s share of the entity’s interest based on the owner’s use of the debt proceeds. An optional allocation rule permits passthrough entities to allocate their interest expense to expenditures during the taxable year other than distributions, if certain requirements are met. The special rules for passthrough entities will not apply to taxpayers who use such entities to avoid or circumvent the interest tracing rules.
3. What expenses paid in connection with the production of investment income are deductible?