Tax 6-7 Analyze a situation to calculate the amount of investment interest expense that is deductible. Flashcards
Investment Interest Expense
Investment interest is interest paid or accrued on a debt that was incurred to purchase property “_____ for investment.” In this context, property held for investment is any property that produces portfolio-type income, such as interest from annuities, bonds, CDs or savings accounts, royalties, or capital gains not derived in the ordinary course of a trade or business.
(6-7, pg 49)
“held”
The capital gains that may be included here must be gains from these types of assets. In this context, property held for investment does not include rental properties. Stock is deemed to be held for investment, even if not dividend-paying. Long-term capital gains and dividends are subject to special rules, as discussed later in this chapter.
Investment Interest Expense
Investment interest also includes interest on a home mortgage that is used to purchase property held for investment. Investment interest does NOT include interest incurred to purchase _____ exempt securities.
(6-7, pg 49)
tax
There is no deduction allowed on funds borrowed to purchase tax-exempt securities, even if the taxpayer utilizes a home equity (second mortgage) loan. This same rule applies if the loan is used to purchase single-premium life insurance.
Investment Interest Expense
For individual taxpayers, an investment interest expense deduction is allowed to the extent of the taxpayer’s net investment income. The investment interest expense is an itemized deduction, and is not subject to the 2% of AGI limitation. Net investment income is the _____ of investment income over deductible investment expenses (other than the interest), after application of the 2%-of-AGI limitation. Remember that these deductible investment expenses are a Tier II miscellaneous itemized deduction, and are only deductible to the extent that they exceed 2% of AGI.
(6-7, pg 50)
excess
Investment income is the sum of the gross income from property held for investment. Net long-term capital gain and qualified dividend income may be included in investment income only if the taxpayer elects to forgo the preferential treatment on these long-term capital gains and qualifying dividends. Investment expenses are the expenses, except for interest, that are deductible expenses (Tier II) directly related to the production of investment income. For example, subscriptions to investment journals, fees for investment advice, and safe deposit box rental fees are considered investment expenses.
Calculating Investment Interest Expense
Assume that, in the current tax year, Joe Hathaway had investment income (interest and short-term capital gains) of $15,000 and AGI of $65,000. He incurred investment adviser fees of $2,000 and paid investment interest of $20,000 on a debt, the proceeds of which were used to purchase stock, mutual funds, and bonds. To calculate Joe’s investment interest expense for the current tax year, the following steps should be taken.
(6-7, pg 50)
Determine the net investment income:
Step 1
$65,000 AGI
* 2%
= $1,300 AGI Limitation
Step 2
$2,000 Investment Advisor fees (Tier II)
- $1,300 Subtract AGI Limitation (Step 1)
= $700 Deductible Investment Advisor fees
Step 3
$15,000 Investment Income
- $700 Subtract Deductible Investment Advisor fees
= $14,300 Investment Interest Expense Deduction (allowed up to Interest Expense)
- $20,000 Subtract Investment Interest Expense
= $(5,700) If negative, carried forward to next year
Investment Interest Expense
For individual taxpayers, an investment interest expense deduction is allowed to the extent of the taxpayer’s _____ investment income.
(LO 6-7)
Net
Investment Interest Expense
_____ income is the sum of the gross income from property held for investment.
(LO 6-7)
Investment
Investment Interest Expense
Module Check
- Which one of the following statements is incorrect regarding investment interest expense?
- Investment interest expense is deductible up to the amount of the net investment income.
- Excess investment interest expense cannot be carried forward into succeeding tax years.
- Interest paid or accrued to purchase or carry tax-exempt investments is not deductible.
- Net investment income is the excess of investment income over deductible Tier II investment expenses.
(LO 6-7)
- Excess investment interest expense cannot be carried forward into succeeding tax years.
Excess investment interest expense CAN be carried forward into succeeding tax years.
Investment interest expense is deductible up to the amount of net investment income.
The interest on funds borrowed to purchase tax-exempt investments is not deductible.
The excess of investment income over the Tier II investment expenses (after the 2% of AGI limitation) is the amount of net investment income.
Investment Interest Expense
Module Check
- A taxpayer uses a home equity loan to obtain funds to purchase municipal bonds. Which of the following is correct regarding the income tax implications of this scenario?
- The interest on the home equity loan is fully deductible.
- The interest on the home equity loan is not deductible.
- The municipal bond interest becomes taxable.
(LO 6-7)
- The interest on the home equity loan is not deductible.
While the interest on a home equity loan (up to $100,000) is generally deductible, there is no deduction allowed if the proceeds are used to purchase tax-exempt securities.
While the interest on the home equity loan is not deductible in this situation, the interest on the municipal bond continues to be tax-exempt.
Investment Interest Expense
Module Check
- Which one of the following statements is correct regarding investment expenses?
- Investment expenses, except investment interest expense, are deductible (Tier II) expenses that are directly related to the production of investment income.
- The investment expense deduction is allowed to the extent of gross investment income.
- Investment expenses include those expenses related to a passive business activity in which the taxpayer materially participates.
- Net long-term capital gain is never included in investment income.
(LO 6-7)
- Investment expenses, except investment interest expense, are deductible (Tier II) expenses that are directly related to the production of investment income.
Investment expenses, other than investment interest expense, are generally deductible if they are directly related to the production of the income. These expenses related to the production of income are treated as Tier II miscellaneous itemized deductions; deductible only to the extent that they exceed 2% of AGI.
An investment expense deduction is generally allowed to the extent of net investment income. Investment expenses do not include those expenses related to passive business activities. Net long-term capital gain may be included in investment income if a taxpayer elects to forgo the preferential rate for long-term capital gains.
Investment Interest Expense
Module Check
- Michelle has investment income of $9,000 during the current tax year. She paid brokers’ commissions of $1,000, $2,200 of investment advisers’ fees, and had $7,700 of investment interest expense. Michelle has an AGI of $40,000.
What amount of investment interest expense may be deducted as an itemized deduction?
$5,800
$6,600
$7,600
(LO 6-7)
$7,600
Step 1
$40,000 AGI
* 2%
= $800 AGI Limitation
Step 2
$2,200 Investment Advisor fees (Tier II)
- $800 AGI Limitation
= $1,400 Deductible Investment Advisor fees
Step 3
$9,000 Investment Income
- $1,400 Deductible Investment Advisor fees
= $7,600 Investment Interest Expense Deduction (allowed up to Interest Expense)
- $7,700 Investment Interest Expense
= $(100) If negative, carried forward to next year
Investment Interest Expense
- Mike Wells has interest income of $9,000 in the current tax year. He paid broker commissions on security purchases of $1,000, paid $1,800 of investment adviser fees, and had $8,500 of investment interest expense. His AGI is $25,000.
What amount of investment interest expense may be deducted as an itemized deduction?
(LO 6-7)
$7,700
Step 1
$25,000 AGI
* 2%
= $500 AGI Limitation
Step 2
$1,800 Investment Advisor fees (Tier II)
- $500 AGI Limitation
= $1,300 Deductible Investment Advisor fees
Step 3
$9,000 Investment Income
- $1,300 Deductible Investment Advisor fees
= $7,700 Investment Interest Expense Deduction (allowed up to Interest Expense)
- $8,500 Investment Interest Expense
= $(800) If negative, carried forward to next year
Practice Test 2
Investment Interest Expense
- Jack Johnson, an investor, has the following items related to his investments during the current tax year:
$4,000 Investment Interest Expense
$3,500 Dividend and interest income
$1,750 Investment Adviser’s fees
$50,000 AGI
What is Jack’s maximum allowable investment interest expense deduction for the current year?
$1,750
$2,250
$2,750
$4,000
(LO 6–7)
$2,750
Step 1
$50,000 AGI
* 2%
= $1,000 AGI Limitation
Step 2
$1,750 Investment Advisor fees (Tier II)
- $1,000 AGI Limitation
= $750 Deductible Investment Advisor fees
Step 3
$3,500 Investment Income
- $750 Deductible Investment Advisor fees
= $2,750 Investment Interest Expense Deduction (allowed up to Interest Expense)
- $8,500 Investment Interest Expense
= $(5,750) If negative, carried forward to next year
Practice Test 1
- For the current tax year, Bob Phillips, an individual taxpayer filing a joint return, has $50,000 of investment interest expense and $20,000 of net investment income (interest and dividends). How much investment interest expense, if any, may Bob deduct in the current tax year?
$0
$20,000
$21,000
$30,000
$50,000
(LO 6-7)
$20,000
Investment interest expense is deductible up to the amount of net investment income. The problem tells us that the net investment income is $20,000; thus that is the maximum deduction. The fact that the dividends are included in the net investment income indicates that the taxpayer elected to include them in investment income and is forgoing the preferential rates associated with qualified dividends. The AGI has no bearing on the answer—the AGI would already have been taken into account when computing the net investment income (assuming that there were expenses incurred in the production of income).
