8041 / 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.¹ Prior to 2018, for purposes of this calculation, the 2 percent floor on miscellaneous itemized deductions was applied before investment income is reduced by investment expenses; thus, only those investment expenses that were allowable as a deduction after application of the 2 percent floor operated to reduce investment income.² All miscellaneous itemized deductions subject to the 2 percent floor were suspended for 2018-2025. See Q 8049 for an explanation of the deduction for investment expenses.

“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).³ 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.⁴

The Tax Court held that net gain for purposes of IRC Section 163(d)(4)(B)(ii) means the excess (if any) of total gains over total losses, including capital loss carryovers, from the disposition of property held for investment. The court further held that net gain required inclusion of the taxpayers’ capital losses and capital loss carryovers for purposes of calculating the IRC Section 163(d)(1) limit on the investment interest expense deduction.⁵

Investment income includes qualified dividend income (see Q 702) only to the extent the taxpayer elects to treat such income as investment income.⁶ See also IRC Section 1(h)(11)(D)(i) (qualified dividend income does not include any amount the taxpayer takes into account as investment income under IRC Section 163(d)(4)(B)).