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.
- 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 problem is that Qualified Dividend Income (dividends given preferential tax treatment and taxed at the long-term capital gains rates) 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;
- property that produces a gain or loss not derived in the ordinary course of a trade or business;
- 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 a higher ordinary rate for something that you paid tax on at the lower capital gains rates.
The Jobs and Growth Tax Reconciliation Act, 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 ordinary rates, 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.
- If you borrowed money to buy a car for personal use, it is not deductible.
Margin Accounts—The Big Surprise
According to a January 2004 “Investment News” article, 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 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 Henssler Financial at 770-429-9166 or at [email protected].