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The Investment Interest Deduction: Will You Get Your Deduction This Year? Margin Account Holders May Be In For a Surprise
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The
Investment Interest Deduction:
Will You Get Your Deduction This Year?
Margin Account Holders May Be In For a Surprise
By: Patricia T.
Henssler, C.P.A.
The Henssler Financial Group Position Paper |
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The
Internal Revenue Code allows individuals to borrow money to make an investment,
and to deduct that interest to the extent of their net investment income. The
deduction is limited, in any particular year, to one's net investment income.
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If you incur $5,000 of
investment interest expense, but only have $4,000 of net investment income, your
deduction for interest expense this year is limited to $4,000. The $1,000 not
deducted can be carried over to succeeding tax years.
The new "problem" is
that Qualified Dividend Income (those dividends given preferential tax treatment
and taxed at 15%) is no longer considered investment income, unless you elect
to pay tax at ordinary income tax rates on those dividends. What
generally constitutes investment income? Property held for investment is generally
defined as: -
property
that produces interest, dividends, annuities, or royalties that are not derived
in the ordinary course of a trade or business;
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property
that produces a gain or loss not derived in the ordinary course of a trade or
business;
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an
interest in a trade or business activity that is not a passive activity and in
which the taxpayer did not materially participate.
Net capital gain from the disposition of investment property is not considered
investment income. However,
individuals may elect to treat all or any portion of such net capital gain as
investment income by paying tax on the elected amounts at their ordinary income
rates. In plain English,
this means that you cannot take a deduction at 35% for something that you paid
tax on at capital gains rates (now 0% or 15%).
The
Jobs and Growth Tax Reconciliation Act, better known as the 2003 Tax Bill, specifically
included Qualified Dividend Income as part of Net Capital Gain.
Tax planning will be key should
you no longer have enough investment income, without considering your qualified
dividends. You must consider whether in future years you will have sufficient
investment income to recoup the investment interest. If not, you may wish to consider
electing to treat part of your qualified dividends as investment income. The IRS
cautions, however, that once you have made this election you must have IRS consent
to revoke it. This
means that if your "plan" is to not have sufficient income in the future
to take the interest deduction and you elect to treat qualified dividends as ordinary,
you cannot go back next year and just amend the return, because sufficient investment
income turned up in the succeeding year to take the deduction. You
can, however, amend past years and make the election. If you choose to carry forward
your disallowed investment interest to succeeding years, and it appears after
a couple of years that you will not recoup the deduction, you can amend a prior
year and take the deduction. There are specific directions on how to do this in
the instructions for Form 4952, Investment Interest Expense Deduction.
If you are considering the election to treat
Qualified Dividends (or capital gains) as ordinary income, be sure to consider
it carefully if your itemized deductions are limited as a result of your income
level. You should factor in the "cost" of paying tax at 35%, when you
will not receive the full deduction for your interest expense.
Margin Accounts — Interest
Tracing Rules If
you have a margin account and have borrowed funds on it, you should be aware of
the interest tracing rules. Margin
interest expense is not automatically deducted as investment interest expense.
It depends on what you did with the money. -
If
you borrowed funds to make additional stock purchases or to make other investments
that qualify as investment expenses, then the interest is an investment interest
expense.
-
If
you borrowed money to buy or build a house, then it is mortgage interest (and
subject to the mortgage interest rules).
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If
you borrowed money to buy a car for personal use, it is not deductible.
Margin
Accounts — The Big Surprise According
to an article in "Investment News," the week of January 5, 2004, if
investors hold stock in margin accounts, and the broker lends those shares, you
are not technically receiving dividends on those shares during the period they
are loaned. The investor receives an "in-lieu payment" equal to the
actual dividend payment. The "in-lieu payment" is NOT Qualified Dividend
Income and will NOT receive the benefit of the 15% qualified dividend rate. According
to this article, if you have a "margin account," rather than what is
called a "cash account," whether you have borrowed on it or not, you
have given explicit permission to the broker to lend your shares. (They lend your
shares to hedge funds and short sellers.) Apparently
the only means for determining if your shares were loaned is to wait for the 1099-DIV
to arrive by the end of January and see if you have received Qualified Dividends. If
you have a margin account for the "convenience" of short term borrowing
or "emergencies," I strongly suggest that you get a home equity line
of credit for this purpose and move your assets to a cash account. It
appears that many brokers automatically open margin accounts for their clients.
You may not even know that you will be paying higher taxes than you planned to
pay this year. If you do not know what kind of account you have, you should call
your broker to check the status of your account.
If you would like any further information regarding this issue as well as any other tax related issue, please contact The Henssler Financial Group Tax & Accounting Division at 770-428-4025.
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| ©2008 The Henssler Financial Group | www.henssler.com
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