By Alex Gromelski, Tax Associate
A lesser-known tax strategy available to individuals is the election to treat long-term capital gains and qualified dividends as investment income. Much of the time this election remains unused because it yields undesirable results. However, there are certain situations where it can produce significant savings for taxpayers.
Capital Gains Income
Typically, capital gain income is preferable to other types of investment income due to its lower tax rate. For example, long-term capital gains are taxable at a maximum rate of 20% for those in the highest tax bracket, while other types of investment income is subject to ordinary rates that reach 39.6%. Generally, a taxpayer would prefer to characterize income as a capital gain.
However, investment interest expense can only be deducted to the extent of investment income. This rule presents us with an interesting tax planning opportunity using this election.
In short, a taxpayer may elect to deduct investment interest expenses against long-term capital gains. Though this election causes capital gains to be subject to ordinary rates, it may trigger a deduction that would produce a net benefit to the taxpayer.
To illustrate this net benefit, see the following example.
A taxpayer in the highest possible tax bracket has $80,000 in long-term capital gains and $20,000 in other investment income. The taxpayer also spent $90,000 in investment interest expense. Without making the election, she would only be able to use $20,000 of the investment interest to offset the $20,000 in investment income. In the end, she would carry forward a $70,000 deduction and pay capital gains tax on $80,000 at 20%. This results in a total tax of $16,000 (20% * $80,000). This example excludes state income tax and the net investment sur tax of 3.8%.
Next, we will assume that the taxpayer elects to have the $80,000 treated as investment income. Now the taxpayer has $100,000 in investment income and can thus take the entire $90,000 deduction. This results in $10,000 in investment income that is taxable at ordinary rates, 39.6% in this case. In the end the taxpayer owes $3,960 (39.6% * $10,000). In this example, the taxpayer saved $12,040 in current year taxes. This example excludes state income tax and the net investment sur tax of 3.8%.
However, there can be additional considerations. For example, if the taxpayer above was reasonably certain that she would be receiving $60,000 in investment income next year and spending only $10,000 on investment interest, she may benefit from forgoing the election and carrying forward the investment interest deduction. That way she can use the deduction next year against ordinary income, which is taxed at a higher rate than long-term capital gains. To calculate the optimum scenario, she would need to consider the time value of money and determine whether the future tax benefit truly exceeds the value of the current year savings.
Net Investment Income Tax
Another consideration is the Net Investment Income Tax (NIIT). This additional 3.8% tax on net investment income would need to be considered in the above calculation for taxpayers whose earnings exceed a certain amount. Claiming the expense for investment interest also decreases the NIIT.
Finally, it is important to note that this election generally cannot be revoked. Thus, if a taxpayer files a return and subsequently realizes a change in circumstance that would render the election a disadvantage, she will likely be unable to revoke it. In other words, taxpayers should be reasonably certain of the accuracy of their assumptions before making this election!
Also, please note that it is possible to make the election on an amended return filed up to 6 months after its due date.
Need advice on whether or not to treat your long-term capital gains and qualified dividends as investment income? Keiter can help. We can put you in touch with the resources you need to reach your business goals. 804.747.0000 | Email us.
Alex Gromelski is a Tax Associate at Keiter. Read more of Alex’s insights on our blog.