Press Room: Tax Release

September 09, 2011

Are You Getting the Maximum Tax Deduction for Investment Interest Expense?

It is tax return filing season and the Schedule K-1s are rolling in.  Are you getting the maximum deduction for your investment interest expense related to all of your investments?  In addition to any interest expense you pay directly related to your investments, you may have interest expense deductions from investments in private equity funds, investment funds and hedge funds from which you receive a Schedule K-1.  Reviewing and analyzing these Schedule K-1s along with all the footnotes attached is necessary in order to maximize the benefits from any investment interest expense deduction.

You may deduct both the investment interest expense reported to you on Schedule K-1s as well as what you may pay directly, but the deduction is subject to limitations.  In general, the deduction for investment interest expense is limited to “net investment income.”  This may sound simple but as investment vehicles have become complex so has the calculation of this limitation.

So what is included in net investment income?  Net investment income includes the items you would expect such as interest income, dividend income and capital gains.  But note that long-term capital gains and qualified dividends, which are subject to a 15% tax rate, are only included if you make an election that limits the benefit of the deduction to 15%.

Net investment income may also include less familiar items reported on the K-1s such as Section 988 currency gains/losses, Section 475 mark to market gains/losses, PFIC income, trader expenses, swap income, etc.  The determination of how each of these items can affect net investment income can be a difficult task.  And finally, any deductions related to the investment income, such as management fees, must be subtracted.  Note that the calculation of net investment income should be repeated for alternative minimum tax (AMT) and may result in a different limitation.

Once you know the amount of deductible investment interest expense, it is necessary to determine whether it is reported as an itemized deduction or reported as a business deduction related to a “stock and securities trader” activity.  Taking the time to determine how much of the deduction may be treated as a business deduction is important to maximizing the potential benefit.

Any investment interest that is limited by net investment income in a given year can be carried forward indefinitely for both regular and AMT.  With proper planning, it is often possible to substantially increase the benefits of any carryover.

WTAS can help you understand the benefit that you’re getting from your investment interest deductions and how that benefit might be improved with some analysis and planning.