With the passage of the Tax Cuts and Jobs Act of 2017, many itemized deductions previously available to taxpayers were either limited or eliminated. Due to the significant increase in the standard deduction, many taxpayers have abandoned the task of accumulating expenses once cherished to offset taxable income as an itemized deduction.
However, investors should be aware that the deduction for investment interest expense is one of the few surviving benefits still included as an itemized deduction. As a result, it is imperative that investors understand the tax rules associated with interest paid on portfolio loans before acting on any investment opportunity. Investors who do not fully understand the tax law could potentially create a tax bill substantially higher than expected.
What is Investment Interest?
Investment interest is interest paid on loans where the proceeds of such loans are used to purchase investment property. For these purposes, investment property is defined as property held for investment that produces interest, dividends, annuities, royalties and gains and losses not derived in the ordinary course of business. It also includes an interest in a trade or business in which you do not materially participate. So, for instance, if you borrowed money to purchase shares in your brother-in-law’s company and you were considered a passive investor with respect to the management of the company, then the interest associated with the borrowed money would be considered investment interest.
The Rule of Interest Tracing
The most important rule to understand with respect to classifying interest as investment interest is the concept of interest tracing. This rule allocates debt and interest (other than qualified residence debt and interest discussed below) according to the use of the proceeds from the loan, not the property used to secure the loan. Simply put, if an individual secures a loan with business property but uses the loan to buy a personal vehicle, the interest is not deductible.
The easiest way to trace disbursements from a loan is to keep the proceeds separate from any other funds. This way, more complicated tracing rules will not apply.
Determining if Investment Interest will Produce a Tax Benefit
Once interest is classified as portfolio or investment interest, there are still other factors that need to be considered to determine whether it will produce a tax benefit.
- Determining the Extent of the Allowable Deduction: Investment interest expense is only deductible to the extent of investment income for any given year. Any amounts of investment interest that exceed investment income may be carried forward to potentially be used in future years.
- Determining Applicable Investment Income: Investment income includes taxable interest, non-qualified dividends, annuities, royalties and short-term capital gains. Qualified dividends and long-term capital gains are not considered investment income for these purposes due to their favorable tax rate. It is possible to make an election to tax these items at ordinary income tax rates to include them as investment income and therefore use the expense. In a few cases, this could be beneficial.
- Reporting the Allowable Deduction: Individual taxpayers should use Form 4952 to determine the amount of investment interest allowable as an itemized deduction. All allowable amounts are then transferred to Schedule A and compiled with other available itemized deductions (i.e., taxes not exceeding $10,000 for married couples filing jointly mortgage interest, charitable contributions, etc.) to determine if itemized decurion exceed the available standard deduction.
Using Qualified Resident Interest to Purchase Investment Property
Taxpayers that receive proceeds from home acquisition indebtedness up to $750,000 for married couples filing jointly ($375,000 for single filers and couples filing separately) may use such proceeds for whatever purpose without regard to the interest tracing rules discussed above. If proceeds from such qualifying loans are used to purchase investment property, the related interest is not considered investment interest subject to potential limitations; rather, this interest is fully includible as an itemized deduction on Schedule A of Form 1040.
However, changes under the Tax Cuts and Jobs Act of 2017 do have significant implications with respect to second mortgages and home equity lines of credit secured by a primary or secondary residence. Whereas such loans were once considered home acquisition indebtedness to a maximum of $100,000 in proceeds, the TCJA now has excluded such debt from this definition. As a result, proceeds from these types of debts are no longer fully deductible as an itemized deduction and are, instead, subject to the interest tracing rules. Consequently, the ultimate use of the proceeds of these loans will be the determinative factor in the treatment and deductibility of the related interest.
Contact Bennett Thrasher
Do you have tax questions about interest expense from portfolio loans or other investments? For more information on investment interest expenses or for tax assistance, please contact Richard Bartolanzo by calling 770.396.2200.