8041 / What is investment income for purposes of the investment interest deduction?

“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)).

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.⁷ 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.⁸

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.⁹ (However, the IRS has ruled privately that a taxpayer was permitted to make a late election to treat capital gains as investment income based on the Service’s conclusion that the taxpayer had acted reasonably and in good faith, and that granting the extension would not prejudice the interests of the government.)¹⁰

The elections are made on Form 4952, “Investment Interest Expense Deduction” and may not be revoked for that year, except with IRS permission.¹¹ See, e.g., Let. Rul. 200146018 (where the Service ruled that the taxpayers’ correct status as securities traders would have entitled them to treat such gains as investment income anyway; thus, allowing them to revoke their prior election did not prejudice the interest of the government or cause undue administrative burdens). However, making the election in one year does not bind the taxpayer for any other year.¹²

In an unpublished private letter ruling, the taxpayer (whose former tax return preparer had recently died) prepared his return for year one using commercial software. The return involved significant securities transactions, including net long-term capital gains. The return also reflected investment interest expense, some of which was disallowed due to lack of net investment income. The taxpayer was not aware that he could have made an election to include in investment income all or part of the net capital gain; the necessity for making the election; nor how it could impact his return or the provisions for amending the return until the taxpayer subsequently sought help from a tax professional in the summer of year three. Upon review of year one and year two, the tax professional noted the item and explained the situation to the taxpayer. The taxpayer requested consent to revoke the default election made inadvertently when the taxpayer filed the return, and to permit him to make an informed election by filing an amended return. The Service granted the taxpayer an extension of time for making the election, requiring the taxpayer to file a revised Form 4952 and Schedule D and to include a copy of the ruling with an amended return for year one. The Service also granted consent to revoke the first election made on the year one return.¹³

The Service privately ruled that: (1) the term “property” (under IRC Section 163(d)(5)(A)(i)) included interest-free loans (which are deemed to yield gross income as a result of interest imputed under IRC Section 7872) to a tax-exempt foundation; (2) any imputed interest income deemed received by the taxpayer on the potential loan from the line of credit to the foundation would be investment income (under IRC Section 163(d)(4)(B)(i)); and (3) any interest paid by the taxpayer on the line of credit used to make the potential loan to the foundation would be investment interest (under IRC Section 163(d)(3)(A)).¹⁴

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.¹⁵