Investment Expenses: What's Tax Deductible?

December 14, 2023 Hayden Adams
The IRS allows various tax deductions for expenses related to producing taxable investment income. Do yours qualify?

Since maximizing your tax deductions has the potential to reduce your tax burden, let's look at some of the most common deductible investment expenses and how they can reduce your taxable income.

No more deduction for miscellaneous investment-related expenses

For tax years 2018 to 2025, "miscellaneous itemized deductions" have been eliminated. Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), taxpayers were allowed to deduct expenses such as fees for investment advice, IRA custodial fees, and accounting costs necessary to produce or collect taxable income. 

For tax years 2018 to 2025, "miscellaneous itemized deductions" have been eliminated. Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), taxpayers were allowed to deduct expenses such as fees for investment advice, IRA custodial fees, and accounting costs necessary to produce or collect taxable income. 

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For tax years 2018 to 2025, "miscellaneous itemized deductions" have been eliminated. Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), taxpayers were allowed to deduct expenses such as fees for investment advice, IRA custodial fees, and accounting costs necessary to produce or collect taxable income. 

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For tax years 2018 to 2025, "miscellaneous itemized deductions" have been eliminated. Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), taxpayers were allowed to deduct expenses such as fees for investment advice, IRA custodial fees, and accounting costs necessary to produce or collect taxable income. 

Investment interest expense

If you itemize, you may be able to deduct the interest paid on money you borrowed to purchase taxable investments—for example, margin loans to buy stock or loans to buy investment property. You wouldn't be allowed to deduct the interest on a loan to buy tax-advantaged investments such as municipal bonds.

The amount that you can deduct is capped at your net taxable investment income for the year. Any leftover interest expense gets carried forward to the next year and can potentially be used to reduce your taxes in the future. 

To determine your deductible investment interest expense, you need to know the following:

  • Your net investment income, which normally includes ordinary dividends and interest income. It does not include investment income taxed at the lower, long-term capital gains tax rates or municipal bond interest, which is not taxed at all.
  • Your total investment interest expenses for loans used to purchase taxable investments.

Let's look at an example. Here, Mary has $150,000 of total income, $8,000 of net investment income (from ordinary dividends and interest income), $10,500 of investment interest expenses from a margin loan, and $13,000 of other itemized deductions (such as mortgage interest and state taxes).

In this example, Mary has $8,000 in net investment income and $10,500 in investment interest expenses. She is allowed to deduct the smaller of the two amounts. Thus she is able to reduce her taxable income by $8,000 with an additional $13,000 in itemized deductions.

*Example assumes that Mary itemizes deductions.
The example is hypothetical and provided for illustrative purposes only.

Because of the investment interest expense deduction and other itemized deductions, Mary's taxable income has been reduced from $150,000 to $129,000.

Qualified dividends

Qualified dividends that receive preferential tax treatment aren't considered investment income for these purposes. However, you can opt to have your qualified dividends treated as ordinary income.

In the right circumstances, electing to treat qualified dividends as ordinary income can increase your investment interest expense deduction, which could allow you to pay 0% tax on the dividends instead of the 15% or 20% tax that qualified dividends normally receive. Here's an example of how it might work.

In addition to the information in the first example, let's say Mary has $2,000 of qualified dividends, on which she would normally pay $300 in tax ($2,000 x 15% long-term capital gains tax rate). If Mary elected instead to treat the qualified dividends as ordinary income, she could boost her net investment income from $8,000 to $10,000. As a result, she would be able to deduct more of her investment interest expense in the current year—and pay no tax on the qualified dividends. 

In this example, Mary has an additional $2,000 in qualified dividend income. This brings her total investment income up to $10,000. This is still less than her investment interest expenses. Thus, she can deduct $10,000 from her taxable income with an additional $13,000 in itemized deductions.

*Example assumes that Mary itemizes deductions.
The example is hypothetical and provided for illustrative purposes only.

Because Mary is a tax-savvy investor, she was able to reduce her taxable income from the original $150,000 to $127,000. That $10,000 investment interest expenses deduction resulted in $2,220 of tax savings (assuming an ordinary tax rate of 24% and a long-term capital gains tax rate of 15%).

Note: The election to treat qualified dividends as ordinary dividends should not be taken lightly. Once made, the election can only be revoked with IRS consent. Consult with your tax professional before implementing this tax strategy.
 

Capital losses

Losing money is never fun, but there might be a silver lining. Capital losses can be used to offset your capital gains. If your capital losses exceed your capital gains, up to $3,000 of those losses (or $1,500 each for married filing separately) can be used to offset ordinary income and lower your tax bill. Net losses of more than $3,000 can be carried forward to offset gains in future tax years.

To make the most effective use of capital losses, keep track of your investment cost basis. The cost basis is generally equal to an investment's purchase price plus any expenses necessary to acquire that asset, such as commissions and transaction fees. 
 

Where to get help

The IRS also has some resources that provide examples and detailed explanations of the topics included in this article, including: Publication 550, Publication 529, and the instructions for Form 1040, Schedule A, Schedule D, and Form 4952

Be sure to consult your tax professional (CPA, lawyer, or enrolled agent) about your situation, preferably well before the end of the year. No matter the time of year, it's also a good idea to check with your tax advisor before you make any decisions that might have significant tax consequences. 

Learn about tax-smart strategies.

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Investing involves risk, including loss of principal.

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, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.

When considering a margin loan, you should determine how the use of margin fits your own investment philosophy. Because of the risks involved, it is important that you fully understand the rules and requirements involved in trading securities on margin.

Margin trading increases your level of market risk.

Your downside is not limited to the collateral value in your margin account.

Schwab may initiate the sale of any securities in your account, without contacting you, to meet a margin call.

Schwab may increase its "house" maintenance margin requirements at any time and is not required to provide you with advance written notice.

You are not entitled to an extension of time on a margin call.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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