Deductibility of Investment Expenses
Section 212 of the Internal Revenue Code allows the deduction of expenses incurred to produce or collect income or to manage property held for income. However, how the expenses are deducted depends on the nature of the expenses.
To be deductible, an investment expense must satisfy the general requirements of a business expense, which must be both necessary and ordinary. A business expense is necessary if it is required for the conduction of the business. A necessary expense is one that would be incurred by any business of a particular type. An ordinary expense is one that is normal or customary for the type of business and that is not a capital expense. An ordinary expense does not have to be recurring. They can arise because of special circumstances, but must be paid to continue business. Expenses must have a reasonable and proximate relation to either the production or collection of income or for the management of property held for income. So, for instance, if the taxpayer owns 100 shares in a company and spends $1000 to attend the shareholders' meeting to vote her shares, then no deduction will be allowed because it is not a reasonable expense compared to the income nor is it a necessary expense, since it will not affect the income earned on the stock. If an expense is unreasonable, then the excess amount is not deductible. Reasonableness is a question of fact and depends on the circumstances. Excessive salaries and rents that are paid to investors of closely held corporations may not be deductible, especially if the payments are proportional to their ownership of stock in the corporation, in which case, it will be viewed as dividends, which are taxable to the corporation and to the shareholders.
Direct expenses that are incurred directly to acquire or dispose of income-producing property are fully deductible because they adjust the tax basis of the property. These expenses include, for instance, depreciation and transaction charges for buying and selling property, such as brokerage commissions charged for the trading of securities.
Example: You buy $100 worth of stock and pay a $4 brokerage commission. Later, you sell the stock for $200 and pay another $4 brokerage commission. Your total profit is equal to: $200 – $100 – $8 = $192
But the deductibility of other types of expenses is more limited. Investment interest and other investment expenses are tax deductible, but only as itemized deductions. Therefore, they are actually only deductible if the taxpayer's total itemized deductions exceed the standard deduction, which is based on filing status. Furthermore, investment expenses other than interest are classified as miscellaneous deductions that are subject to a 2% AGI floor, so only that portion of the taxpayer's total miscellaneous deductions that exceeds 2% of the taxpayer's adjusted gross income are deductible. However, if the taxpayer has professional trader status, trading as a business, then all investment expenses are fully deductible as business expenses on Schedule C, Profit or Loss from Business.
|Investment Interest Deduction Benefit||=||Investment Interest Expense||×||Total Itemized Deductions – Standard Deduction|
Total Itemized Deductions
Example: Investment Interest Deduction
- Investment Interest Expense = $1000
- Total Itemized Deductions = $9000
- Standard Deduction = $6000
- Investment Interest Deduction Benefit over Standard Deduction = $1000 × ($9000 – $6000)/$9000 = $1000 × $3000/$9000 = $333.33
The full amount of investment interest can be listed as an itemized deduction, up to the amount of net investment income:
Net Investment Income = Interest + Nonqualified Dividends + Royalties + Annuities + Net Short-Term Capital Gains – Direct Investment Expenses
Direct investment expenses are those that are incurred in buying or selling the investment, such as sales commissions. Net long-term capital gains, including capital distributions from mutual funds, and qualified dividends do not count as investment income in regards to this interest deduction unless the taxpayer elects to treat some or all of that income as such on Form 4952, Investment Interest Expense Deduction. However, this election will eliminate the preferred tax rates on that portion of long-term capital gains and qualified dividends used to offset investment interest expenses, but the taxpayer may choose this, nonetheless, to offset investment expenses against investment income for the current year.
Investment interest is the interest on debts incurred to buy or carry investment property, such as securities in a margin account, or to buy a business. The interest on loans to buy tax-free securities is not deductible, however. Interest related to a passive activity is subject to passive activity rules; the deduction for this interest is figured on Form 8582, Passive Activity Loss Limitations. The deductibility of the interest expense that is incurred by a partnership and paid to a limited partner is limited by the investment interest deduction. The deductibility of investment interest may also be limited by at-risk rules, since the taxpayer cannot deduct any more than what is at risk in the investment.
Disallowed investment interest can be carried forward. The investment interest limitation applies to any property that produces interest, dividends, royalties, or annuities — what is generally referred to as portfolio income. In other words, it is neither business income nor passive income. Investment interest also covers loans for the purchase of property held for potential capital gains that was not used in a trade or business, but was held for investment purposes, and that is also not a passive activity. Investment interest also includes income earned from a trade or business activity in which the taxpayer did not materially participate but is not considered a passive activity under tax law, such as the purchase of rental properties to earn rental income in which the taxpayer satisfies active participation rules. It does not include any other types of interest that are covered by other sections of the tax law, such as loans for a qualified residence.
Any excess of interest deductions over investment income can be carried forward indefinitely. Investment interest is calculated on Form 4952, Investment Interest Expense Deduction, and, along with Schedule A, Itemized Deductions, attached to Form 1040.
Debts to Buy Tax-Exempt Securities
Generally, the money borrowed to buy tax-exempt securities is not deductible, since no tax is paid on the interest income.
If expenses were incurred for both tax-exempt and taxable securities, and the expenses are not specifically allocable to either type of security, then only the proportion of the expenses equal to the taxable income divided by the total income is deductible:
Investment Interest Deduction = Investment Expense × Taxable Income / Total Income
|Investment Expense Deduction||$300||= Investment Expenses × Taxable Interest/Total Interest|
However, if a taxpayer pays cash for tax-exempt securities but then takes out a loan to buy taxable securities or to purchase a home or other property or to invest in a business, then there will be a presumption by the IRS that the taxpayer arranged his affairs so that the money borrowed could be applied to the business or other property rather than to the purchase of tax-exempt securities.
Therefore, in these situations, the IRS will infer that the purpose of the loan was to buy tax-exempt securities, except in the following cases:
- the tax-exempt investment is insubstantial, being less than 2% of the adjusted basis of the taxpayer's portfolio;
- the loan was a personal loan, such as for a home mortgage;
- the loan is for an active business and does not exceed the needs of the business.
Miscellaneous Investment Expenses
Unlike investment interest, other investment expenses are not only an itemized deduction, but are subsumed under the category of miscellaneous deductions, calculated on Schedule A, that are subject to the 2% AGI floor. Hence, only miscellaneous expenses above 2% of the taxpayer's AGI are deductible.
|Miscellaneous Expense Deduction||=||Miscellaneous Expense||×||Total Miscellaneous Expenses – 2% × AGI|
Total Miscellaneous Expenses
Since miscellaneous investment expenses are also an itemized deduction, the benefit of the deduction over just claiming the standard deduction is even less:
|Miscellaneous Expense Deduction Benefit||=||Miscellaneous Expense Deduction||×||Total Itemized Deductions – Standard Deduction|
Total Itemized Deductions
Note that if the taxpayer's total itemized deductions are less than the standard deduction, then there is no tax benefit to claiming any itemized deductions, including the miscellaneous expense deduction.
Example: Miscellaneous Expense Deduction
- Total Miscellaneous Expense = $5000
- Total Itemized Deductions = $9000
- Standard Deduction = $6000
- AGI = $100,000
- Miscellaneous Expense Deduction = $5000 × ($5000 – .02 × $100,000)/$5000 = $3,000
Miscellaneous investment expenses include:
- fees for investment advice or management
- travel to a broker or financial advisor's office
- tax preparation fees
- software and online services used to manage investment accounts
- investment publications, such as the Wall Street Journal, whether in print or online
- fees for safe deposit box rentals that are used to store investment-related documents or actual investments, such as valuable coins or stamps
Investment expenses do not include expenses related to passive activities or to a business or trade. Expenses related to running a business or trade or expenses incurred for property held for rent or royalty income are not subject to the 2% floor and are deductible from gross income. Some investment expenses include counseling and professional fees, custodian fees, office rent and clerical help, and state and local transfer taxes.
Example: Deducting Paid or Accrued Investment Interest and Other Investment Expenses
- Short-Term Investment Income = $14000
- Long-Term Capital Gains + Qualified Dividends = $2000
- Total Investment Interest Paid or Accrued + Carryover Interest = $17,000
- AGI = $50,000
- On Form 4952, Investment Interest Expense Deduction:
- Investment Income Before Interest Deduction = Interest + Nonqualified Dividends + Royalties + Annuities + Short-Term Capital Gains = $14,000
- Smaller of Net Investment Income or Total Investment Interest Including Carryover = $14,000
- Transfer $14,000 to Schedule A on the appropriate line
- Interest Carried Forward = $17,000 – $14,000 = $3000
- On this form, the taxpayer can elect to include up to $2000 of the long term capital gains + qualified dividends to deduct that additional amount in interest, but then the taxpayer would not benefit from the favorable tax rates on the long-term capital gains and qualified dividends that was used to offset investment interest. In virtually every case, it would be better to carry the interest forward to offset ordinary investment income in the future.
- On Schedule A, Itemized Deductions:
- Investment Interest = $14,000
- Other Investment Expenses = $1500
- Non-Deductible Other Expenses = AGI × 2% = $1000
- Keep in mind that other expenses can include non-investment expenses, such as unreimbursed employee expenses and tax preparation fees, so the total of these expenses are deductible only to the extent that it exceeds 2% of AGI.
- Non-Deductible Other Expenses = AGI × 2% = $1000
- Deductible Other Investment Expenses = $1500 – $1000 = $500
- Total Itemized Deductions = Investment Interest + Deductible Other Investment Expenses = $14,000 + $500 = $14,500
- Transfer $14,500 to Form 1040 as the total of itemized deductions.
Deductibility of Loan Interest Depends on How the Loan Money Is Used
Whether loan interest is deductible depends on how the loan proceeds are used: if for taxable investments or an active business, then the interest is fully deductible, but is not deductible for personal purchases. The interest incurred for passive activities is deductible only against passive income, which is figured on Form 8582, Passive Activity Loss Limitations.
If the taxpayer obtains a loan and deposits it in an account, and uses the account to make different types of purchases with the money, then what interest is deductible depends on when the disbursements are made and for what purposes.
If the loan proceeds are mixed with non-borrowed funds, then there is a 30-day disbursement rule where any expenses paid within 30 days either before or after the deposit of the loan proceeds is treated as being paid by the loan proceeds, so if the money is used for a purpose that qualifies the interest as deductible, then the interest on the loan is fully deductible even if it is mixed with non-borrowed funds.
If a loan is used to buy several types of property, then the loan is repaid, it is assumed to be repaid in the following order:
- personal debt;
- investment or passive activity debt;
- debt from real estate activity in which the taxpayer actively participates;
- former passive activity debt;
- business debt.
Example 1: On January 2, you borrow $10,000 and put it in your checking account. On May 1, you use $3000 to buy stocks. Therefore the $3000 is treated as investment expense for the period from January 2 to May 1. On October 1, you buy a TV for $2000. Up until you buy the TV, the interest is considered investment interest. However, when you buy the TV, that is considered nondeductible personal interest on the $2000. The remaining $5000 continues to be considered investment interest.
Example 2: You borrow $6000 on June 1 and put it in your checking account which also has non-borrowed funds. You buy furniture for $5000 on June 10 and on June 15 you buy stock for $6000. Therefore, because the purchase for investments was made within 30 days, the entire $6000 can be treated as investment interest.
Example 3: You borrow $10,000 on February 1, and on July 1 you pay $6000 for stocks and on August 1 you pay $4000 for furniture. On December 1, you repay $8000 of the loan. The personal part of the proceeds is considered repaid first, so the entire $4000 that was used to buy furniture is retired, and the remaining $4000 is applied to that portion that was used to buy stock.
Interest can only be deducted in the year that it is actually paid, except for an accrual-basis taxpayer, who can claim the interest expense as it accrues. Interest is not deductible if it is simply added to the loan amount in a margin account, but can be deducted either when the taxpayer pays the margin interest or the account has collected dividends, interest, or security sale proceeds that can be used to pay the interest.
For partial repayment of a loan for which the allocation between principal and interest is not specified, then the assumption is that some of the payment is allocated to the interest first and then to principal. For involuntary payments, such as for a foreclosure, the sales proceeds are applied to principal first and then to interest, unless there is a contrary agreement.
Generally, prepaid interest is not deductible in the year paid. Rather, it must be allocated pro rata over the term of the loan.