Investment Interest Expense

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Investment interest expense is interest paid on money borrowed to buy property held for investment, such as interest on securities in a margin account. A taxpayer can deduct investment interest expense, but the deduction is limited to the taxpayer’s net investment income (described below). Investment interest expense incurred to produce tax-exempt income, and interest on straddles, is not decuctible. Investment interest does not include qualified home mortgage interest or any interest taken into account in computing income or loss from a passive activity.

Net Investment Income

Net investment income is the excess of a taxpayer’s gross income from property held for investment plus net gains from the dispostion of property held for investment, over the taxpayer’s investment expenses. Investment expenses are expenses connected with the production of investment income, such as amounts paid for management of securities. Investment expenses does not include investment interest expense, or any expenses associated with a passive activity. If investment expenses are included as a miscellaneous itemized deduction on Schedule A (Form 1040), line 22, the 2% adjusted gross income limitation on Schedule A, line 25 may reduce the amount of investment expenses to be used in determining net investment income.

Qualified Dividends / Net Capital Gain Election

In general, qualified dividends and net capital gain from the disposition of property held for investment are excluded from investment income. But a taxpayer can elect to include part of these amounts in investment income. However, the qualified dividends and net capital gain that a taxpayer elects to include in investment income are not eligible to be taxed at the preferential qualified dividends and capital gains tax rates. Taxpayer’s should consider the tax effect of using the qualified dividends and capital gains tax rates before making this election. Once made, the election can be revoked only with IRS consent.

Example: A taxpayer received $5,000 of interest income and $3,000 of qualified dividends. The taxpayer incurred $2,000 of investment interest expense, and also had other investement expenses of $3,500 (after the 2% of AGI limitation). The taxpayer’s net investment income (not including the qualified dividends) is $1,500 ($5,000 minus $3,500). Absent the election to include the qualified dividends in investment income, the taxpayer is allowed $1,500 of investment interest expense (it is limited to net investment income). The remaining $500 of investment interest expense can be carried over to subsequent years. However, the taxpayer can elect to include $500 of the qualified dividends in investment income, which will allow an investment interest expense deduction of the full $2,000. However, the $500 of qualified dividends that the taxpayer elects to include in net investment income is disqualified from the preferential qualified dividends tax rate.

Source: IRS Publication 550

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