With the passage of the Tax Cuts and Jobs Act of 2017 (“TCJA”), 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 allowed to offset taxable income as an itemized deduction.
However, taxpayers 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 comprehend 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.
Example: Mary borrows $100,000 from the bank to invest in her brother-in-law’s new restaurant business. Mary does not actively participate in the business and is not involved in company management. Because she is considered a passive investor in the restaurant business, the interest paid on the $100,000 loan will be treated as investment interest expense.
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 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 increase the limitation on deductible investment interest 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, mortgage interest, charitable contributions, etc.) to determine if itemized deductions exceed the available standard deduction.
Using Home Loans to Purchase Investment Property
A taxpayer who takes out a mortgage loan on their primary or secondary residence and uses the proceeds to buy, construct, or substantially improve that residence can deduct the interest paid as qualified residence interest on Schedule A. However, the TCJA limited the deduction for qualified residence interest to the amount of interest paid on a loan balance of up to $750,000, with any excess interest expense being disallowed. In some cases, tax savings can be achieved by taking out a mortgage loan after the purchase or construction of the mortgaged property and using the proceeds to purchase investment property, thus causing the interest to be treated as investment interest expense instead of qualified residence interest.
Example: John is planning to purchase a new home worth $5 million. He finances the purchase by taking out a $750,000 mortgage on the property, supplemented with $4,250,000 in cash from savings and sales of investments. Several months after the transaction and unrelated to the acquisition of the home, John takes out a second mortgage for $3,250,000 on the property, using the proceeds to purchase stock and bond investments. The interest on the first mortgage of $750,000 will be deductible as qualified residence interest, and the interest on the second mortgage of $3,250,000 will be deductible as investment interest expense, subject to applicable limitations.
Another change implemented by the TCJA has significant implications with respect to home equity lines of credit secured by a primary or secondary residence. Prior to 2017, the interest on these loans was deductible on loan balances of up to $100,000, regardless of how the proceeds were used, but the TCJA repealed this deduction. As a result, interest paid on home equity lines of credit not used to buy, construct, or substantially improve a residence is no longer deductible as qualified residence interest and is 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.
Do you have tax questions about interest expense from portfolio loans or other investment-related debt? For more information on investment interest expense or for tax assistance please contact your Bennett Thrasher tax advisor by emailing firstname.lastname@example.org.