Tax Deductions Related to Investment Income

What You Can Deduct

As we all know, people look to grow their money by making good investments. Earnings received from investments such as stocks, bonds, and mutual funds are taxable for income tax purposes unless they are derived from tax exempt investments such as municipal bonds. These taxable earnings include interest, dividends, annuities and royalties. They also include the capital gains and losses from the sale of the investments.

Since the income from investments is taxable, the related costs incurred to hold the investments and earn the income are tax deductible as investment expenses. A common type of investment expense is stock brokerage fees. The net of the investment income less the investment expenses is the net investment income.

What About Borrowing?

Most of the time investments are acquired with extra money that people have to invest, but that’s not always the case. Sometimes investors borrow money to acquire the investments. The loan may be from a bank or it may be a margin loan from the brokerage firm. Regardless, the loan will include interest. The interest paid on a loan to buy investments qualifies as a tax deduction. It is called investment interest expense. However, the amount of the deduction is limited to the amount of net investment income. Any amount not deducted may be carried forward to a future year.

Election Options

In computing net investment income, qualified dividends and long term capital gains are not included. This is because both are subject to special tax rates and are not taxed at ordinary tax rates. For most taxpayers, the maximum rate is 15% (20% for taxpayers in the 39.6% tax bracket). However, taxpayers may make an election to have all or some of the dividends and long term capitals gains taxed at the ordinary tax rates instead of the special rates. If so, then those dividends and long term capital gains are treated as investment income for purposes of deducting investment interest.

This is a strategy to use when investment interest exceeds net investment income and all of the interest cannot be deducted. Treating all or some of the dividends and long term capital gains as investment income will allow for the deduction of additional investment interest expense. The tax savings from deducting more interest expense often exceeds the additional tax resulting from taxing the dividends and long term capital gains at a higher rate. However, before making this election, one should consult with their tax advisor to decide if it’s the best strategy for their particular situation.

Article contributed by Tony Dulo, MKS&H Tax Manager

About MKS&H: McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick. MKS&H helps owners and organizational leaders become more successful by putting complex financial data into truly meaningful context. But deeper than dollars and data, our focus is on developing an understanding of you, your culture and your business goals. This approach enables our clients to achieve their greatest potential.

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