It is well worth an investor’s time to learn the specifics of the investment interest expense deduction. This knowledge will better prepare a taxpayer for a meeting with his or her tax professional. By providing all the appropriate information at once during a busy tax season, the taxpayer may save the tax professional time and, consequently, reduce not only a tax liability but accounting fees as well.
Investment interest expense is that which is paid, or accrued, on debt that is incurred to purchase investments. In order to deduct the interest, these investments cannot be held in a trade or business. A taxpayer can deduct investment interest only to the extent that there is “net investment income.” Net investment income is calculated by subtracting investment expenses, other than the interest expense, from total investment income. After the amount of allowed investment interest expense is determined on Form 4952, it is entered as an itemized deduction on line 14 of Form 1040 Schedule A.
Investment income includes dividends, royalties, interest, annuities, gains from the sale of investment property, and some distributions from mutual funds. It does not include income from residential rental property. Normally, net capital gains resulting from the sale of investment property are not included in the calculation of net investment income. Qualified dividends also are not usually included. However, the taxpayer can elect to include these items but may lose the benefit of the lower tax rates afforded to them.
Besides interest expense, other expenses that relate to the generation of investment income include legal and accounting fees as well as fees paid to investment advisors and trust custodians. Also included are investment expenses from flow-through entities such as partnerships and S Corporations.
Interest paid on a home mortgage is not investment interest expense. Also, interest paid on debt incurred to purchase securities yielding tax-exempt income is not a deductible expense. Municipal bonds are an example of this type of security.
If a taxpayer has an investment in a “passive activity,” the expenses related to that activity are not investment expenses for purposes of calculating net investment income. A passive activity is one in which the taxpayer does not “materially participate.” Most residential rental activities are passive activities.
Keep in mind that Form 4952 is used solely to calculate the investment interest expense deduction. The income and expense items comprising the calculation will be reported elsewhere on the tax return. For example, dividend and interest income are reported on Schedule B, and any capital gain distributions are still reported on line 13 of Form 1040 or Schedule D.
As stated, the deduction of investment interest is limited to the amount of net investment income. If the amount of investment interest expense is greater than the current year’s net investment income, the excess can be carried forward to the following year. In the following year, the interest is treated as if paid, or incurred, during that year.
Again, once the interest expense amount is determined, the figure is reported as an itemized deduction on line 14 of Schedule A. What about the other investment expenses besides interest? These are reported on line 23 of Schedule A as a miscellaneous itemized deduction and included in the total of all miscellaneous and job expenses. The total of these expenses must exceed two percent of the taxpayer’s adjusted gross income in order to be included in itemized deductions.
There are other limitations and restrictions regarding the investment interest deduction. As always, consult with a tax professional.