If you borrow money and use the proceeds to buy assets held for investment, such as margin debt used to buy securities, generally the interest on the debt is deductible for both regular tax and alternative minimum tax purposes. However, there are limitations that apply that may reduce the benefits of this itemized deduction.
First, interest is only deductible to the extent you invest in securities that produce taxable income. You cannot deduct interest you incurred to produce tax-exempt income. For example, if you borrow money to invest in municipal bonds, which are exempt from federal income tax, you cannot deduct the interest.
Second, your investment interest deduction is limited to your net investment income. Your net investment income, for the purposes of this deduction, generally includes taxable interest, nonqualified dividends and net short-term capital gains, reduced by other investment expenses. In other words, net investment income includes only investment income taxed at ordinary income tax rates and not investment income taxed at preferential capital gain tax rates such as long-term capital gains and qualified dividends.
However, you can carryover any disallowed interest. You can then deduct the disallowed interest in a later year when you have excess net investment income.
If you have a large amount of investment interest but your deduction is limited, since most of your investment income is from qualified dividends and long-term capital gains, you may elect to treat qualified dividends and/or net long-term capital gains as investment income in order to deduct more of your investment interest. But if you do, that portion of the qualified dividend or long-term capital gain will be taxed at ordinary-income rates. The effect is to convert a deduction that offsets income taxed at ordinary rates, as high as 39.6%, to a deduction that offsets income taxed at capital gain rates, usually 15% or 20%. If you are unsure you will ever have sufficient ordinary investment income in the future, it may make sense to take the reduced benefit now, and not wait several years (if at all) to potentially receive the full benefit.
If you’re wondering whether you can claim the investment interest expense deduction on your 2016 return, please contact us. We can run the numbers to calculate your potential deduction or to determine whether you could benefit from treating gains or dividends differently to maximize your deduction. You can reach me at HZemel@Berdonllp.com or contact your Berdon advisor.
Hal Zemel, a Tax Partner at Berdon LLP, New York Accountants, has nearly 25 years in public accounting and advises businesses in the manufacturing, distribution, advertising, and real estate sectors.