Peter J Reilly, Contributor

I focus on the tax issues of individuals, businesses & more

Interest expense may or may not be deductible. Generally speaking, whether you can deduct interest, how you can deduct it and in what year you can deduct it is determined by how you spent the money that you borrowed. One category of potentially deductible interest is investment interest. A common way to get investment interest is to buy stocks on margin. Investment interest expense is deductible in a given year to the extent of “investment income”. Investment interest expense that exceeds “investment income” is carried forward indefinitely.

It would seem that someone who is investing profitably will not have much problem deducting all their investment interest expense. Such is not the case. Long term capital gains and dividend income subject to the 15% rate are not included in “investment income”. If they were there would be a tax arbitrage opportunity, since the investment interest expense is an itemized deduction that might have a 35% benefit. There is relief, though. You can elect to have dividends and long term capital gain taxed at the ordinary rate, which allows them to be included in “investment income”. If you are not generating other types of investment income, it is probably a good idea. How much of your dividends and capital gains should you elect to be included in investment income ?

If you think you will have other types of investment income in the future, that becomes a judgment call, but if you are of the bird in the hand school and want to minimize the current years tax, you will elect to have enough of your 15% income converted so that you can deduct all the investment interest expense that you have. You certainly do not want to convert more than that. All you would be doing then is increasing your tax. That would be stupid. If I was desiging tax software, I would make it so you couldn’t even do that, which brings us to the sad story of Private Letter Ruling 201217004.  Now pay attention, because there will be an assignment at the end.

The PLR concerns a trust.  Trusts are taxed in a similar manner to individuals, at least as far as investment interest is concerned:

For Year 1 and Year 2, Trust hired an accounting firm (Firm) to prepare its Form 1041, U.S. Income Tax Return for Estates and Trusts (“Return”). The Firm prepared the Return by entering the relevant data into a tax software computer program (“Software”) but a keying error was made on line 4g of Form 4952, Investment Interest Expense Deduction, that resulted in an inadvertent election to include the entire amount of qualified dividend income and net capital gain in each year. For Year 1 $a [Say $25,000]was treated as investment income for purposes of the deduction for investment interest expense. The actual amount of investment interest in Year 1 was $b [Say $10,000], an amount significantly less than $a. .