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Investment Expenses: What's Tax Deductible?

Investment Expenses: What’s Tax Deductible?

Key Points
  • Due to recent tax law changes, certain investment-related expenses are no longer deductible if you itemize.

  • If you borrowed money to purchase taxable investments, you may still be able to use the interest expenses from the loans to reduce your taxable investment income.

  • Up to $3,000 of capital losses can be used to offset your ordinary taxable income.

The IRS allows taxpayers various tax deductions for investment-related expenses if those expenses are related to producing taxable investment income. With the passage of the Tax Cuts and Jobs Act (TCJA), some of the rules related to the deductibility of investment expenses have changed. If you itemize deductions on your annual tax returns, make sure you’re up to date on the changes so you don’t miss out on any deductions.

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

Prior to the passage of the TCJA, taxpayers were allowed a tax deduction for certain expenses known as “miscellaneous itemized deductions.” Miscellaneous itemized deductions included 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, these deductions have been eliminated.  

Many investors have been rightfully concerned about the loss of these deductions. However, many people who thought they were getting these deductions may not actually have been receiving a tax benefit due to certain limitations in the old tax code. Before the TCJA, three main limitations caused people to lose a portion or all of their deductions: 

  • The 2% adjusted gross income (AGI) limitation on miscellaneous itemized deductions required your miscellaneous itemized deductions to be greater than 2% of your AGI before you could receive any benefit.
  • The 3% Pease limitation could reduce your overall itemized deductions after you earned a certain amount of income. 
  • The alternative minimum tax (AMT) could kick in if your income and deductions were too large, resulting in a loss of all or a portion of your itemized deductions.

The net effect of these limitations resulted in quite a few taxpayers thinking that they had received a deduction, but in reality, they had lost the deduction or had seen a limited benefit. 

It’s important to remember that you generally can’t look at an individual tax law change to know how it’s going to affect you. You have to look at all the changes combined to know what ramifications they might have. For many taxpayers the combination of all the changes within the TCJA (such as the new tax rates and brackets) could offset the loss of miscellaneous itemized deductions. If you’re concerned about how this change will affect you, be sure to talk to your tax advisor, who can help you estimate the effect on your tax returns for 2018 to 2025.  

Investment interest expense

If you itemize your deductions, you may be able to claim a deduction for your investment interest expenses. Investment interest expense is the interest paid on money borrowed to purchase taxable investments. This would include margin loans you use to buy stock in your brokerage account. In such cases, you can deduct the interest on the margin loan. (This wouldn’t apply if you used the loan to buy tax-advantaged investments such as municipal bonds.)

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

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

  • Your total investment income for investments taxed at your ordinary income rate
  • Your total investment interest expenses (for loans used to purchase taxable investments)

To calculate your deductible investment interest expense, you first need to determine net investment income. This normally includes ordinary dividends and interest income, but does not include investment income taxed at the lower capital gains tax rates, like qualified dividends, or municipal bond interest, which is not taxed. Then, compare your net investment income to your investment interest expenses. If your expenses are less than your net investment income, the entire investment interest expense is deductible. If the interest expenses are more than the net investment income, you can deduct the expenses up to the net investment income amount. The rest of the expenses are carried forward to next year.

For example, let’s say Mary has $150,000 of total income, $8,000 of investment income (from ordinary dividends and interest income), and $10,500 of investment interest expenses from a margin loan.

Example #1
Calculation of deductible investment interest expenses
Step 1    

The allowable deduction is the smaller of these:

  • Net investment income
  • Investment interest expenses


 

$8,000

$10,500
 
Deductible investment interest expenses   $8,000
     
Step 2    
Leftover investment interest expenses
(carried forward to next tax year)
$2,500  
     
Change in Mary’s taxable income    
Taxable income   $150,000
Minus the deductible investment interest expenses   $8,000
Taxable income (after investment interest expenses)*  

$142,000

*Example assumes that Mary itemizes deductions. 

Because of the investment interest expense deduction, Mary’s taxable income has been reduced from $150,000 to $142,000.

Qualified dividends

Qualified dividends that receive preferential tax treatment aren’t considered investment income for purposes of the investment interest expense deduction. However, you can opt to have your qualified dividends treated as ordinary income.

In the right circumstances, electing to treat qualified dividends as ordinary dividends 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 in 2018, on which she would normally pay $300 in tax ($2,000 x 15% tax rate). If Mary elected 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.

Example #2
Calculation of deductible investment interest expenses if qualified dividends are treated as ordinary income
Step 1    
Investment income (from example #1)   $8,000
Plus qualified divided income   $2,000
Equals total investment income   $10,000
     
Step 2    

The allowable deduction is the smaller of these:

  • Net investment income
  • Investment interest expenses
 

 

$10,000

$10,500

 
Deductible investment interest expenses   $10,000
     
Leftover investment interest expenses
(carried forward to next tax year)
$500  
     
Change in Mary’s taxable income    
Taxable income   $150,000
Minus deductible investment interest expenses   $10,000
Final taxable income*   $140,000

*Example assumes that Mary itemizes deductions. 

Because Mary is a tax-savvy investor, she was able to reduce her taxable income from the original $150,000 to $140,000. That’s a $10,000 reduction in taxable income, which could result 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 is 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.

For more information about maximizing the tax benefit of capital losses and understanding strategies like tax loss harvesting, see “Reap the Benefits of Tax-Loss Harvesting to Lower Your Tax Bill.”

Don’t forget about the cost basis of your investment

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. Later, when you sell your investment the cost basis is used to reduce the taxable gain. For more on cost basis, see “Save on Taxes: Know Your Cost Basis.”

What to do now

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.

In addition, 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 enter into any transaction that might have significant tax consequences.

What you can do next

Important Disclosures

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.

The type of securities and accounts mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.

This information does not constitute and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

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

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