Updated: Dec 1, 2019
Let's say you paid a large amount of interest on a home equity loan with the intention of being able to deduct the interest on your income tax return. That deduction you are looking forward to is limited to your investment income, So, if the interest, realized gain or other types of investment income you earned during the year does not equal to or exceed the amount of loan interest you paid, then you will not be able to deduct the full interest amount during that tax year.
Do not get discouraged just yet, this where the tax tip kicks in. If you are not able to deduct all of your investment expenses on your individual or trust tax return due to limited investment income, then making an election to tax capital gains and qualified dividends at ordinary income rates might be something to consider.
Net Investment Income
Before I dig deeper, let’s define a few of these terms:
Investment income generally includes your gross income from property held for investment (such as interest, dividends, annuities, and royalties).
Investment expenses generally include interest paid or incurred to acquire investment property and expenses to manage or collect income from investment property.
Net investment income is investment income less investment expenses.
Qualified Dividends and Capital Gains
The IRS definition of investment income does not include qualified dividends or net capital gains. Qualified dividends are dividends paid during the tax year from domestic corporations and qualified foreign corporations. So, dividends paid out by companies on any of the major stock exchanges are usually qualified dividends, while dividends paid out by a real estate investment trust (REIT) are usually nonqualified. Net capital gains are the profits from the disposition of investment property (including capital gain distributions from mutual funds). Both qualified dividends and net capital gains are usually taxed at reduced rates.
Note: qualified dividends to have to meet holding period criteria to be taxed at the reduced rate.
Investment Interest Deduction
Although the reduced tax rate is nice, electing to tax qualified dividends and net capital gains at the higher income tax rate could be a more effective tax strategy. The reason is, the investment interest expense deduction is limited to net investment income. When the election is made, qualified dividends and net capital gains are treated as investment income, increasing your investment interest deduction.
Of course, the decision to make this election will take some strategic planning. Here a few tax items to consider when evaluation the benefits of the election:
Is it more beneficial to forego the election and carry over the investment interest expenses to future years?
Are you expecting significant changes to net investment income in future years?
Will your tax liability decrease with a higher qualified dividend/capital gain tax rate and higher investment interest expense deduction?
How will making the election impact your state tax liability?
How to Make the Election
If you determine that the election is the best tax strategy for you in the current year, you can make the election on Form 4952. To make the election, Enter on line 4g the amount you elect to include in investment income (don't enter more than the sum of lines 4b and 4e). Also enter this amount on whichever of the following applies;
The Qualified Dividends and Capital Gain Tax Worksheet, line 5, in the Instructions for Form 1040.
The Schedule D Tax Worksheet, line 3.
Schedule D (Form 1041), line 25.
The Qualified Dividends Tax Worksheet, line 3, in the Instructions for Form 1041.
Once the election is made, it can be revoked only with IRS Consent.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.