Investment Interest Deduction
Posted on August 5, 2008
Filed Under Deductions, Federal Income Tax
The Tax Reform Act of 1986 put a chill on many individual investors by enacting what is informally known as the “investment interest limitation,” in other words, limiting the deduction for interest paid to purchase or hold investments (including interest on margin accounts) to the amount of net investment income from such investments. Investment interest expense (abbreviated in this article as investment interest) is one of the itemized deductions not subject to phase out for high income taxpayers. If investment interest exceeds net investment income, it can be carried forward indefinitely.
Investment interest is defined as interest paid on debt to buy or carry investment property. Investment interest to buy or carry tax-exempt securities (e.g., municipal bonds) or other tax-free investments is not deductible. On the whole, investment interest does not include interest related to passive activities, mortgage interest, or capitalized construction period interest.
Investment property comprises the following:
- Property such as stocks, bonds, insurance portfolio products, patents, etc. producing dividends, interest, annuities, and royalties not arising in the ordinary course of a trade or business owning such property;
- Property in (1) above but aggregated in a mutual fund or other pooling device and generating gain or loss from holding or selling such property;
- Property held for investment in non-passive activities, although an exception has been granted for one type of passive activity, namely, a working interest in an oil or gas property held directly or through an entity not limiting taxpayer’s liability; and
- Any interest in a non-passive trade or business activity in which the taxpayer is not a material participant.
Gross income from investment properties includes the following items:
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Portfolio income, that is, income from annuities, dividends, interest, mutual funds, real estate investment trusts, gain or loss from the sale or other disposition of property held for investment or producing portfolio income, and net income from publicly traded partnerships;
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Income from any non-passive interest in a trade or business in which the taxpayer doesn’t materially participate;
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The ordinary income portion of proceeds from the sale or disposition of investment property, maddeningly described in Section 163(d)(4)(B)(ii) of the Internal Revenue Code as “the excess (if any) of — (I) the net gain attributable to the disposition of property held for investment, over (II) the net capital gain determined by only taking into account gains and losses from dispositions of property held for investment”; and
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At the price of being taxed at higher rates than the capital gains tax but with the benefit of increasing the current year’s deduction for investment interest, a taxpayer may elect, using the IRS expense form (pdf file), to group what normally cannot be grouped with investment income, that is, the net capital gain from the sale or disposition of investment property or qualified dividends eligible for lower rates (in 2008, the rate for qualified dividends is 0% for individuals in the 10% and 15% tax brackets and 15% for those in the 25%, 28%, 33%, or 35% tax brackets). (Total interest expense is then transferred to the interest schedule [pdf file] on Form 1040.)
Net investment income is gross income less reasonable investment expenses, other than interest, with a credible and proximate relation to the production or collection of income from investment properties. There is a catch–investment expenses are classified as miscellaneous expenses and therefore deductible only to the extent they total more than 2% of adjusted gross income. Common investment expenses include accounting fees, investment counseling, legal fees, and rent for safe-deposit boxes.
Other relevant articles on the investment interest deduction follow below:
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Investment income (pdf file)
Many happy returns, Roger
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