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Archives:Investment Interest and Margin Interestby Roy A. Lewis, E.A. As many of you know, there are various types of interest expense. They include qualified residence interest, passive interest, and business interest. Each type has its own set of rules that allow for deductibility. Today we'll be discussing investment interest. Investment interest is interest paid on loans to hold investment property. That seems reasonable, right? But, investment property doesn't just mean real estate. It can also be stocks, or bonds, or other securities or property — any type of investment property, either real or personal, that you are holding for investment purposes. It doesn't include interest that you pay for your main home, second home, rental income property, or property that you use in your trade or business. Some of these things might seem like investments, but you've got to understand that, in this case, the term "investment property" is a technical term that only applies to specific property. This is a very important distinction, and one that you should be able to make if you find that you do pay investment interest. Many of you are also familiar with the term "margin" interest. That's the interest that your broker charges you when you borrow against your brokerage account. You might think that margin interest has its own set of rules, but it really doesn't. Margin interest is nothing more than a type of investment interest, and is subject to all of the rules and regulations for investment interest. We'll discuss this in more detail in a minute, but there is a situation where margin interest is not considered "investment interest" for tax purposes — when you borrow on margin against your brokerage account and use the money for a non-investment purpose. (Again, we'll explain the whys and wherefores shortly... for now, just understand that how you use the money you borrow matters to Uncle Sammy.) Investment interest is deductible up to the amount of net investment income received, and is reported on Schedule A using Form 4952 as a back-up computation. The definition of net investment income can get a bit tricky. In general, it includes your gross income from investment property (such as interest, dividends, short-term capital gains, and elected long-term capital gains) less any investment expenses that you might have (which might include expenses for investment publications and similar expenses). As noted above, when you are dealing with long-term capital gains, an additional decision must be made. You can stick with business as usual and have your long-term capital gains taxed at their preferential tax rate. If you do so, you can't use any of those long-term gains as investment income to offset investment interest expense. Or, you can elect to treat all or some of your long-term capital gains as investment income. The upside is that those long-term gains can then be used to offset investment interest expenses. The downside? You lose the ability to have those long-term gains taxed at the preferential capital gains tax rates. The Long-Term Gain ElectionIf you're confused, we're not surprised. Electing to treat long-term gains as investment income is a difficult concept to understand. So, let's take a closer look. As we mentioned, net investment income doesn't include long-term capital gain income (i.e., gain from investment and capital assets held for more than one year). But, you're allowed to elect to treat all or part of your long-term net capital gains as investment income — provided you reduce the amount of net capital gain eligible for the preferred long-term capital gains tax rate by the same amount. In other words, if you elect to treat X dollars of long-term capital gain as investment income, you must decrease your long-term capital gains by X dollars. This is an important choice that you have to make... and you really should be aware of the impact. Example: Consider Lois, a single person with the following income and expenses for tax year 1999:
If Lois does not treat any capital gains as investment income, her investment interest expense deduction is limited to the amount of her net investment income (in this case, it's her interest income of $3,000). So she deducts $3,000. Her tax, using the 1999 Schedule D worksheet, amounts to $16,834. What happens to the rest of the investment interest expense beyond the $3,000? Lois will carry that $2,000 forward to tax year 2000, and it will be available as an investment interest expense deduction as long as she has net investment income in 2000. Note that Lois ends up losing the ability to deduct that last $2,000 on her 1999 tax return. To avoid this, she can elect to treat $2,000 of long-term capital gains as investment income. Doing so means the full $5,000 of investment interest expense is deductible, and her tax (according to the Schedule D worksheet) is $16,434. No investment interest expense is carried over to tax year 2000. So, the election saved Lois $400 in taxes for the year. Would it have been more beneficial for Lois not to make the election, and simply carry over the $2,000 of investment interest to the following year? It depends on a number of factors, including her anticipated net investment income and long-term capital gains for the next year. While making the election may save you tax dollars in the short run, it may cost you tax dollars in the long run. Your best bet is to gaze deeply into your crystal ball to see what the future may bring. Just don't forget that, in many cases, a bird in the hand really is worth more than two in the bush. You are generally better off making the election and reducing your taxes today. But that might not be true for everyone, so make sure to review your specific situation to see what is best for you. Investment Interest Myths, Tips, and TrapsThere are a number of misconceptions and potential traps regarding investment interest, and especially so with margin interest. Here are four of the biggies, along with the true story for each of them:
Still Holding Your Interest?The rules for the investment interest deduction can be complicated — especially if the transactions involved are complicated. And if you use the loan proceeds for something other than the purchase of investment property (such as Schedule E rental property interest, Schedule C business interest, etc.), the rules get even more complicated. You'll likely have to deal with the interest tracing rules and interest reallocation rules. So, if you decide to borrow against investment property you hold -- and hope to deduct the interest in some way, shape, or form -- you must be careful and understand the rules completely. Make sure that you're familiar with them. Your minimum required reading would include IRS Publications 550 and 535, and IRS Form 4952 and the associated instructions. You'll be glad you did. If you like the way Roy Lewis simplifies confusing tax issues, check out his just-published book, The Motley Fool's Investment Tax Guide 2000: Smart Tax Strategies for Investors. This handy 360+ page guide covers just about every tax aspect of a typical Fool's life: investing, marriage, children, education, homes, home offices, retirement accounts, medical expenses, and much more.) July 21, 2000
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