Investment Interest Expense

 Is Key To Deduction

Is investment interest, such as margin interest, deductible against capital gains? Does it matter if the gains are long term or short term gains? S.Z., Noblesville

Typically, investment interest is deductible as an itemized deduction on Schedule A, so before any other considerations, you must be able to itemize your deductions in order to reduce your taxable income by your investment interest expense. Line 13 of the Schedule A is the line you use for reporting investment interest.

Investment interest refers to interest paid on money borrowed for the purpose of purchasing investment property that will generate taxable income. This includes margin interest, assuming you purchased taxable securities with your margin account. Interest on money borrowed to purchase tax exempt securities, such as municipal bonds, is not deductible.

The basic rule for deducting investment interest expense is that the amount you deduct cannot exceed your interest and ordinary dividend income from investments for the year. If your investment interest paid during 1999 is less than your interest and dividend income, you can report the entire amount of investment interest expense on your Schedule A and deduct this amount on your 1999 tax return.

If your investment interest expense is greater than your dividend and interest income, you have a couple of options available to you.

• You can elect to carry the excess interest expense over to next year’s tax return. Fill out Form 4952, Investment Interest Expense Deduction, and attach this form to your 1999 tax return. Use this form to show the amount of investment interest expense you paid during 1999, your investment income, and the amount of your current deduction (equal to your investment income). The balance is carried over to next year.

• You can elect to offset the excess investment interest expense against net capital gain income. In other words, if you have capital gain dividends, or if you sold securities at a gain, and those gains exceed any capital losses you may have, you can add that net gain to your other investment income and deduct investment interest up to the total amount. Long term and short term gains are combined for this calculation. You must fill out Form 4952 to show how you calculated your investment interest expense deduction.

Beware of the downside of using your net capital gain income to generate an investment interest expense deduction. Any capital gain income that is used to provide you with an investment interest deduction is not eligible for the lower income tax rates on capital gains.

Here’s an example. You paid $2,000 in margin interest in 1999. Your dividend and interest income for 1999 totals $1,200. You are entitled to deduct $1,200 of your margin interest expense as investment interest expense on Schedule A.

You also have net capital gains of more than $800, and your marginal tax rate is 31%. If you choose to carry the remaining $800 of margin interest over to your 2000 tax return, your 1999 capital gains will be taxed at the maximum capital gain tax rate of 20%, so you will pay $160 in tax on your $800 in gains this year. The margin interest will carry over to next year where you will deduct it and receive a 31% benefit for the deduction, or a tax savings of $248, but you won’t see this savings for a year. A tax of $160 offset by tax savings of $248 gives you a net savings of $88, over a period of two years.

If you elect instead to deduct the interest in 1999, you will receive the $248 tax benefit this year. You will also pay tax on the gain of $800 at your 31% rate, for a tax of $248, which effectively wipes out your tax savings. You lose the savings on your 2000 tax return, but you’re not out the $160 this year.

You should perform a calculation like this one yourself, to see exactly how this situation applies to your taxes, before making a decision on how to use your margin interest deduction. One factor to keep in mind when you make this calculation is that if your investments don’t generate enough interest and dividend income to offset the interest you pay, you may never see the benefit of your margin interest deduction unless you use your capital gain income to offset this deduction.