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?

The tax code allows individuals a deduction for ordinary and necessary expenses paid in the year for the production or collection of income, or paid for the management, conservation, or maintenance of property held for the production of income, whether or not, in either case, they are business expenses. Personal management of one’s investments is not the conduct of a trade or business. This is so without regard to the amount of time spent managing the investments or to the size of the portfolio.

The deduction applies to expenses in connection with both income and gain from sales. The deduction is taken by a cash method taxpayer in the year the expense is paid. This deduction is limited to expenses related to the production of income that is subject to federal income tax. However, it may be income realized in a prior year or anticipated in a subsequent year (as, for example, defaulted bonds bought with the expectation of gain on resale). The expenses are deductible even if no income is realized in the year. Expenses not for the production of income or the management, conservation, or maintenance of property held for the production of income, but paid in connection with activities carried on primarily as a sport or hobby may be limited.  Whether a transaction is carried on primarily for the production of income or for the management, conservation, or maintenance of property held for the production of income rather than primarily as a sport or hobby or recreation depends on the facts and circumstances involved.

To be deductible, expenses must be reasonable in amount and bear a reasonable and proximate relation to the production or collection of taxable income or the management, conservation, or maintenance of property held for the production of income.

Expenses that enter into the determination of income or loss of a passive activity are subject to the limitations of the passive loss rule and are not deducted as investment expenses. In general, a passive activity is any activity involving the conduct of a trade or business in which the taxpayer does not materially participate and any rental activity. Generally, an individual may deduct aggregate losses for the year from a passive activity only to the extent that they do not exceed aggregate income from passive activities in that year.

Expenses of a passive activity that are allocable to income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business are not treated as passive activity expenses, but rather are treated under the general rules applicable to other investment expenses.

Investment expenses are generally treated as miscellaneous itemized deductions. These expenses are, therefore, deductible from adjusted gross income only to the extent that the aggregate of all miscellaneous itemized deductions for the taxable year exceeds 2 percent of adjusted gross income. Only those investment expenses that are deductible (i.e., those remaining after the 2 percent floor has been applied) are considered in the calculation of net investment income.  For purposes of this calculation, the 2 percent floor is applied against all other miscellaneous itemized deductions before it is applied against investment expenses.

The more common expenses, provided they have the required relationship to the production of income (and deductible only to the extent that they exceed the 2 percent floor) include: (a) rental expense of a safe deposit box used to store taxable securities; (b) subscriptions to investment advisory services; (c) investment counsel fees; (d) custodian’s fees; (e) services charged in connection with a dividend reinvestment plan; (f) service, custodian, and guarantee fees charged by the issuer of mortgage-backed securities, (g) bookkeeping services; (h) office expenses in connection with investment activities, such as rent, water, telephone, stamps, stationery, etc.; and (i) premiums paid for indemnity bonds required for issuance of new stock certificates to replace certificates mislaid, lost, stolen, or destroyed.

The Tax Court has denied a deduction for mutual fund shareholders’ pro rata share of the annual operating expenses incurred by the mutual funds in which they owned shares. Because publicly offered mutual funds pass through income to shareholders on a net basis (i.e., gross income minus expenses), the Tax Court concluded that the shareholders had already received the benefit of a reduction in income for these costs and, therefore, were not entitled to deduct the operating expenses as investment expenses.

Partners in an investment club partnership formed solely to invest in securities and whose income is derived solely from taxable dividends, interest, and gains from security sales may deduct their distributive shares of the partnership’s reasonable operating expenses incurred in its tax year that are proximately related to the partnership’s investment activities. Operating expenses include postage, stationery, safe deposit box rentals, bank charges, fees for accounting and investment services, rent, and utility charges. Investment partnerships are not engaged in business because management of activities with respect to one’s own account is not a trade or business.

Expenses may be nondeductible because they are personal in nature, or because they are not ordinary and necessary. Examples of such expenses would include: newspaper and magazine costs, where it is not clear that the publications were used principally for investment activities rather than personal activities; travel to attend shareholders’ meetings; fees paid for maintenance of interest paying checking accounts where the fee is charged for the privilege of writing checks instead of maintaining the interest bearing account and the checks written are personal; travel expenses going to watch a broker’s ticker tape regularly but not directly related to any particular transactions entered into for profit; maintenance of an art collection where personal pleasure, not investment, was the most important purpose for the collection; and expenses of maintaining a personal residence. An expense not otherwise deductible that is paid in contesting a liability against an individual does not become deductible simply because property held for production of income might have to be used or sold to satisfy the liability.

Expenses may be nondeductible because of other Internal Revenue Code sections. For example, expenses that are capital in nature are not deductible, such as broker’s commissions and fees incurred in connection with acquiring property. These types of expenses are instead added to the basis of property. Similarly, selling expenses are offset against the selling price used in determining capital gains and losses, not deducted as expenses. A safe purchased to store property used in the production of income was ruled to be a capital expenditure. Expenses to defend, acquire, or perfect title to property are capital in nature. Legal expenses incurred to recover taxable interest and dividends are deductible, but portions allocable to the recovery of a capital asset (e.g., stock) are not deductible, but rather are capitalized. No deduction is allowed for expenses allocable to attending a convention, seminar, or similar meeting unless the expenses are ordinary and necessary expenses of carrying on a trade or business.

The Service has determined that a flat fee (representing a specified percentage of the market value of the assets in a taxpayer’s account) that is paid to a stockbroker for investment services is not a carrying charge (under IRC Section 266) and, thus, cannot be capitalized. Instead, the Service stated, a flat fee is better viewed as a currently deductible investment expense.

See ThinkAdvisor’s complete tax planning lineup on our 23 Days of Tax Planning Advice: 2016 home page.