Investment Expenses: What's Tax Deductible?

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Investment Expenses: What's Tax Deductible?
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
September 16, 2004

We all have a silent partner when it comes to our taxable investments. Uncle Sam insists on his cut of our investment income and capital gains, even though he doesn’t share in the risks. At least our good Uncle is kind enough to allow us a few tax breaks!

Of course, we can invest using tax-advantaged vehicles such as 401(k)s, IRAs, annuities, 529 college savings plans, Coverdell Education Savings Accounts and so on. And, if it makes sense for your marginal income tax bracket, you also get a break on tax-exempt municipal bonds held in taxable accounts. Finally, don't forget the new lower rate for long-term capital gains and qualified stock dividends.

But it doesn’t end there. The Internal Revenue Service will let you deduct certain investment expenses you incur on your taxable investments. Check with your tax professional to make sure you’re taking full advantage of investment-related miscellaneous itemized deductions, investment interest expense and capital losses.

Let's look at each of these in turn.

Investment-related miscellaneous itemized deductions
Miscellaneous itemized deductions are generally limited to the amount of expenses over and above 2% of your adjusted gross income (AGI). In other words, there’s a floor below which you lose the ability to deduct.

Here’s an example: Say your AGI is $75,000 and you have $3,000 in miscellaneous itemized deductions. Your 2% AGI floor in this case is $1,500 (2% of $75,000), so you lose the first $1,500 of the $3,000 you claim, but get to deduct the remaining $1,500.

There are a number of miscellaneous itemized deductions not related to investing that you may already be eligible for—tax preparation fees, union dues, cost of uniforms required for work, job-hunting expenses, unreimbursed employee business expenses and so on.

Here’s a list of investment-related expenses you could add to the rest:

Fees for investment counsel and advice, including subscriptions to financial publications
IRA or Keogh custodial fees, if paid by cash outside the account
Software or online services you use to manage your investments
Safe deposit box rent, if you use the box to store certificates or investment-related documents
Transportation to your broker’s or investment adviser’s office
Attorney, accounting or clerical costs necessary to produce or collect taxable income
Charges for automatic investment services and dividend reinvestment plans
Costs to replace lost security certificates

Items you can’t deduct as an investment-related expense include:

Trading commissions—these are "capitalized" to increase your cost basis and/or reduce your taxable sales proceeds
The costs of traveling to attend a shareholder’s meeting
Investment advisory fees related to tax-exempt income—you generally need to prorate these fees based on the portion of tax-exempt investment income vs. total taxable investment income
Borrowing costs associated with life insurance

Investment interest expense
Investment interest expense is the interest on money you borrow to purchase taxable investments. It’s not the source of the loan that matters for tax deduction purposes; it’s how you use the money.

For example, you can deduct the interest on a margin loan you use to purchase stock. But if you use the margin loan to buy a car, you can't deduct the interest (even though such a loan might still make sense in the right circumstances, given the convenience, low rates and flexible repayment options). Likewise, you couldn't deduct the interest on money borrowed to buy tax-exempt municipal bonds.

Investment interest expense is tax deductible up to the amount of any net investment income. Leftover investment interest expense can be carried over for use in future years, without expiration.

To calculate your net investment income—and therefore how much investment interest expense you can deduct—add up your taxable interest income, ordinary dividends and even long-term capital gains and qualified dividends if you make a special election to treat them as ordinary income (more below). Then, subtract any investment-related miscellaneous itemized deductions you actually get to use.

Here's a simplified example: Say you have $10,000 of investment interest expense, $10,000 of taxable investment income and $5,000 of investment-related miscellaneous itemized deductions, $1,000 of which you can use given your AGI. Your net investment income is $9,000 ($10,000 in investment income minus $1,000 in allowable investment-related miscellaneous itemized deductions). You could deduct a matching amount of investment interest expense: $9,000. The remaining $1,000 of unused investment interest expense could be carried forward for potential use in future years.

What about the 2003 tax law changes? How do the qualified dividend rules impact investment interest expense?

Qualified dividends. Qualified dividends that receive the 15% rate (or 5%, depending on your tax bracket) aren’t considered investment income for purposes of the investment interest expense deduction. However, you could elect to treat qualified dividends as ordinary income (just as you can with net long-term capital gain income) to boost the amount you can deduct as investment interest expense. The concept here is that it’s better to pay 0% tax on qualified dividends than 15% tax.

Let's go back to our example: If you also have $1,000 of qualified dividends, you could pay 15% tax on them, or you could elect to treat those dividends as ordinary income and boost your net investment income from $9,000 to $10,000—which means you could now deduct up to $10,000 in investment interest expense in the current year.
Payment in lieu of dividends. If you buy dividend-paying stock on margin and your broker lends out the stock, you don't really receive dividends, you receive payment in lieu of dividends. These payments are treated as ordinary income and aren't eligible for the 15% (or 5%) rate. But the payments are eligible to offset your investment interest expense, so all is not lost.

However, if you already have sufficient ordinary investment income from other sources (or more payment in lieu of dividends than can be used), you're stuck with ordinary tax treatment.

For more on qualified dividends and payment in lieu, log in to see Schwab's special 2003 Tax Cut pages.

Capital losses
Capital losses can be used to offset capital gains without limit in any year. If your capital losses exceed your capital gains during the year, up to $3,000 in losses could be used to offset ordinary income (up to $1,500 each for married filing separately). If your net losses total more than $3,000 in any given year, they don’t expire—you can carry them forward to offset gains in future years.

For comprehensive information on investment expenses, as well as how to report all kinds of investment income, including mutual funds and the rules for netting short-term and long-term capital gains, see IRS Publication 550: Investment Income and Expenses.

Be sure to consult your tax professional about your unique situation, preferably well before the end of the year to make sure you’re taking full advantage of what’s available to you under the law. And no matter the time of year, it’s a good idea to check with your tax pro before you enter into any transaction that might have significant tax consequences.

The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, or legal, tax, or investment advice, or a legal opinion. Individuals should contact their own professional tax advisors or other professionals to help answer questions about specific situations or needs prior to taking any action based upon this information.

The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here are obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

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