Maximize Tax Savings on Investment Interest paid: Electing to Treat Long Term Capital Gains and Qualified-Dividends as Investment Income
By Jennifer Murphy, CPA, Tax Senior Associate | Family & Executive Advisory Services Team
For individuals, estates, and trusts, investment interest paid by a taxpayer is only deductible to the extent of net investment income. Whenever investment interest paid exceeds this net investment income limitation, the nondeductible excess is carried over to the following year and continues to be subjected to the same restrictions each year. Keep in mind that investment interest paid relates only to interest paid on debt used to acquire property held for investment. Investment interest does not include home mortgage interest or personal interest such as interest related to credit card debt. The most common scenario is when a taxpayer borrows on margin to purchase investments in his/ her portfolio.
Net investment income includes taxable interest income, annuity income (not pension related), royalty income not derived from the ordinary course of business, certain oil and gas working interests, non-qualified dividend income, short term capital gain and is reduced by directly connected investment expenses. However, there is an election available to taxpayers that essentially increases the amount of net investment income available for purposes of applying the investment interest expense limitation by designating specified amounts of net long term capital gain and/or qualified dividends as investment income. The great news is, the election can be made for as much or as little net long term capital gain and/or qualified dividends as the taxpayer chooses. Making the election can increase the interest expense deduction for the year, but it doesn’t come without a cost. With this election, the specified investment income will be taxed as ordinary income subjected to the higher/ graduated tax rates. Note that the election cannot be made for gain related to collectibles, IRC Section 1231 gain or unrecaptured IRC Section 1250 gain. Even when considering the higher tax rate on the specified income, making the election can still be a good idea in certain situations.
Before deciding on the election, there are some important points to consider:
- First, if the taxpayer is in the 10% or 15% tax bracket, the election likely should not be made because it would render little or no tax benefit. Specifically, the 10% or 15% tax benefit from the larger investment interest expense deduction would likely be offset by the additional tax resulting from the elected amounts now being taxed at 10% or 15% instead of potentially at the 0% rate that would have otherwise applied.
- Second, if the taxpayer can reasonably predict when adequate net investment income will be available to fully deduct excess investment interest expense, it is possible that the present value of the deferred deduction exceeds the current tax benefit from making the election. If this is the case, then most likely the election should not be made.
However, if the taxpayer does not anticipate having enough investment income at any point in the near future, the election probably should be made to currently deduct as much investment interest expense as possible. The reason being, even if the deduction generates only a 15% or 20% tax benefit, it is likely more beneficial than waiting to take the deduction at some indeterminate time in the future.
In summary, while this election does offer a potential reprieve from continual carryovers from year to year, whether or not to make the election involves many factors that are unique to each taxpayer. The election is made on an annual basis. Once made for a tax year, it cannot be changed without IRS consent. Taking the time to review the facts in each situation can go a long way toward allowing the taxpayer make an informed decision and maximize tax savings.
Questions on this topic? Contact your Keiter representative or Email us.
Jennifer Murphy is a Senior Tax Associate with over 18 years of experience in both the public and private accounting sector. Her experience includes audit, tax, and accounting services for business entities and individuals with an emphasis on taxation. She currently serves as a member of the Family & Executive Advisory Services Team, a segment of our Taxation Specialty Business Services.