Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)

Part III. Investment Income and Deductions

Chapter 12. Deductions from Investment Income

Deduct Your Investment Expenses from Your Income, Even from Ordinary Income

As the saying goes, “It takes money to make money.” With investments it is no different. The good news is that there are several opportunities available to reduce your income by deducting your investment expenses, and there are even a couple tax credits available as well. In this chapter I focus on five categories of opportunities for tax deductions and credits that come from investments:

· Investment interest

· Withdrawal penalties

· Foreign tax credit

· Miscellaneous deductions

· Professional trader status

Investment Interest

At times investors borrow money in order to make an investment. This is done most commonly in “margin” accounts when a broker lends money to an investor in order for them to buy positions in the market. Some investors like this because they can make money on an investment using someone else’s money. The return on the investment can be much greater by employing this strategy.

Example Beth is a skilled stock trader. She has a track record of spotting great deals in the market and taking advantage of them. Beth knows that she can make even more money from her investments if she has a greater amount of capital to invest.

One day she recognizes a growth opportunity in XYZ stock. She has $10,000 available to invest in it and she also borrows an additional $10,000 from her broker for a total of $20,000 to invest in the stock.

It turns out that her hunch was correct and XYZ stock shoots up 25% in its value over the next three weeks, bringing her original position in the stock from $20,000 to $25,000. At that point she sells the stock and pays back the loan of $10,000 to the broker.

By borrowing the $10,000 Beth was able to achieve a capital gain of $5,000, whereas the gain would have been only $2,500 had she used only her own money. In effect, Beth achieved a 50% gain on her money when the stock went up only 25%. Though the broker charges interest on that loan, it is far outweighed by Beth’s gain from the stock that she purchased by borrowing.

Another form of investment interest is incurred when an individual borrows money to buy a business (not to be confused with money that is borrowed to run a company). This interest can be used as an interest deduction as well. It is not the source of the loan that determines the status of the interest, but how the money is used (if it is used to make an investment).

Investment interest expense is deductible up to the total amount of net investment income reported on the return. For the purpose of this deduction, net-investment income includes all investment income that is taxed at ordinary rates (such as ordinary interest, ordinary dividends, and short-term capital gains). Any unused investment interest is carried forward to be used against investment income in future years.

Example Chuck purchased a business four years ago using loans for a large portion of the purchase. Over those four years, Chuck has paid $35,000 in interest. Because it qualifies as investment interest, Chuck could earn short-term capital gains, interest, and dividends up to $35,000 and pay no taxes on that income because it would be offset by the investment interest deduction.

The investment interest expense deduction could actually be used to offset qualified dividends and long-term capital gains as well. To do so you must make an election on your tax return to treat the dividends as ordinary (not qualified) and the gains as short-term (not long). Why would you do this? If you are in the upper income brackets that trigger the 15% or 20% tax on long-term gains and qualified dividends you could use this deduction to reduce or eliminate that tax. A 0% tax is still better than 15% or 20%. However, if you anticipate having ordinary investment income in the future, it may be more beneficial to you to let the unused interest expense roll over to future years.

It is important to note that the interest expense deduction is taken on Schedule A. This means that if you do not have enough total deductions on Schedule A, you will not be able to use the interest deduction.

Withdrawal Penalties

Interest from Certificates of Deposit (CDs) issued by banks is taxed as it is earned, not when it is paid. If you have a CD with a maturity date in a future year you will be taxed on the amount of interest attributable to the current year. This is much like the treatment of Original Issue Discount (OID) interest discussed in Chapter 11.

If you withdraw money from a CD before its maturity date, most banks will charge you a penalty for the early withdrawal—sometimes as much as the interest earned. If this happens, you are allowed to deduct that fee as an above-the-line adjustment to income. This deduction essentially makes up for the tax that you paid in previous years for interest that you never really received, because of the fees.

Foreign Tax Credit

The United States taxes income that you earn from any source, including foreign sources. However, to reduce double-taxation of income, the tax code provides a credit for the income taxes that you are required to pay a foreign country. For a diversified investor it is not uncommon to have foreign taxes withheld from interest or dividends earned from foreign sources. Most often these taxes are reported on the 1099 that is provided by the investment company.

To calculate the credit, a comparison is made between the tax that the investor would pay on the income under U.S. tax law and the tax that is charged by the foreign country. A credit can be claimed on the taxes paid, up to (but not exceeding) the tax that would have been charged under U.S. law.

Example Vanessa owns 1,000 shares of a company based in France, which pays her $2,000 in dividends each year. France requires that the company withhold 20% of all dividends paid as a tax on that income, totaling $400 in withholdings for Vanessa ($2,000 dividends × 20% tax = $400 withheld). Under U.S. law, Vanessa would owe 15% in taxes on that same dividend income, or $300. However, because she has paid $400 in taxes on that income to France, Vanessa can claim a $300 credit on her U.S. income tax return—the lesser amount of what she paid to a foreign country or what she would have paid to the United States on that same income.

The Foreign Tax Credit is non-refundable, so it cannot be larger than the total income tax for the return. If it is greater, the excess portion can be carried back and used one year previous to the year of the return, or carried forward for up to ten years.

Miscellaneous Deductions

As a general rule, expenses that are incurred for the purpose of producing income are deductible against that income. At times, those deductions are reduced, or limited. There are several investment expenses that can potentially be claimed as deductions against your income. Here is a list of some of the more common ones:

· Fees to a financial advisor for investment advice or management of investments

· Software and online services used to manage your investment accounts

· Financial publications

· Custodial fees of qualified accounts (such as IRAs) if paid outside of the account

· Accountant or attorney fees paid to determine taxable income.

· Safe deposit box rental fees, if used to store investment-related documents or actual investments (such as bullion)

· Travel to your broker or financial advisor’s office

All of these expenses are claimed as Miscellaneous Itemized Deductions and are subject to a limitation on their deductibility based on your Adjusted Gross Income (AGI). You may only claim those expenses that are greater than 2% of your AGI. For example, if you have $3,000 in miscellaneous deductions and your AGI is $100,000 you will be able to claim $1,000 of those expenses as a deduction (2% of $100,000 AGI = $2,000 limitation. $3,000 of miscellaneous expenses – $2,000 limitation = $1,000 deductible miscellaneous expenses). This limitation is applied only once to all miscellaneous deductions. It may be that other miscellaneous deductions (such as unreimbursed employee expenses or tax preparation fees) have already crossed the 2% limit and then other miscellaneous deductions like investment expenses would be fully deductible.

In addition to the 2% of AGI limitation, all of your itemized deductions (of any kind) must add up to more than the standard deduction to be of any value. In essence, there are two factors limiting your deduction for investment expenses—the 2% AGI limitation and the total value of all of your itemized deductions combined. Even with these limitations, many taxpayers are able to take advantage of these deductions to reduce their taxable income.

Caution Certain investment expenses are not deductible, such as commissions paid on investments, travel to shareholder’s meetings, and any expenses paid that are related to tax-exempt income.

Professional Trader Status

Are you a “day trader?” Do you actively and regularly trade stocks in your own account? If you do, you may qualify as a professional trader for tax purposes and, as such, receive significant tax benefits.

One major benefit that professional traders receive is the ability to deduct all of their trading-related expenses directly from their investment income. These deductible expenses are not limited to the ones listed in the Miscellaneous Deductions section, but also include all normal business expenses, such as computer and equipment purchases, Internet service, mileage, meals and entertainment, cell phones, trader chat-room fees, subscriptions, home-office expenses, educational courses, and so on. These expenses are not listed on Schedule A, where they would be limited by the 2% of AGI floor, but rather are listed on Schedule C (for businesses) where they are deducted directly from income. Margin interest is also directly deductible and not subject to the limitations of the investment interest deduction rules.

Caution A very common deduction claimed by traders is the cost of educational courses they take to become better traders. Though this deduction is allowed as a continuing education expense, it is not allowed for those learning how to get into the business. For educational expenses to be taken as a business deduction it must be for courses taken to improve one’s skill in an already-established profession, not to qualify an individual for a new business or profession.

Another benefit is that the deduction of net capital losses is not limited to $3,000 per year. If a professional trader loses $20,000 in a bad year, the entire amount can be deducted against all other income because it is considered to be business income. This difference alone can have a dramatic effect on the individual’s total tax bill.

Caution To be able to take the full deduction, a trader must notify the IRS of her status as a professional trader and elect Mark-to-Market accounting treatment. This is a fairly complex process and it would be wise to consult a tax professional for help.

If you have loss carryovers from previous years you may be better off waiting to elect the professional trader status until you have used up those losses by offsetting future gains. Otherwise a gain on the professional-trader business side of your return will be taxed and cannot be offset by the loss carryovers from previous years.

Even though the income and expenses of a professional trader are reported as business income on Schedule C, the trader is not subject to self-employment tax on that income because it comes from capital gains and other investment-related income. It is significant that the professional trader is afforded all of the tax treatments, deductions, and benefits of a business owner and yet does not have to pay the self-employment tax. In fact, I am really surprised that this is the case.

One other significant difference for professional traders is that they are not subject to the “wash-sale” rules. This too is significant, and can open up some real tax-planning opportunities for a trader each year by offsetting income with losses. In addition, the professional trader doesn’t need to report individual trades on his tax return, but can simply report the net results for the year of gains and losses.

Qualifying as a professional trader also allows the individual to set up an employer-sponsored retirement plan, such as a Simplified Employee Pension (SEP) IRA, Savings Incentive Match Plan for Employees (SIMPLE), or a defined benefit plan (among others). All of the benefits of owning a business become available for a trader who elects professional status.

Are you a professional trader? Here’s what it takes:

With all of these great benefits available to professional traders you can bet that there have been a lot of people who have tried to claim this status just so that they can be better off come tax time. The IRS is keenly aware of this temptation and has aggressively fought such abuses. To claim the status of professional trader you have to meet some stringent guidelines, based on the results of important court cases on this subject.

First, you must trade on a regular basis—very regular. In fact, if you are not actively trading a minimum of 50% of the available trading days in the year, you probably don’t qualify. In fact, you need to not only be trading most days, but also transacting multiple times on those days. An average of three trades a day is probably the minimum amount it takes to pass muster. In reality, the number of trades that you make per year should be in the thousands, not in the low hundreds, in order to safely pass this test before the IRS and the courts.

Second, you must be trading for short-term swings in the market, not for long-term growth. Leaving your investments to grow for a year or more makes you more of an investor, not a trader. You must also have an established margin account that you use for pattern trading.

Third, you must be making these trades for your own account, not for clients. If you are managing the accounts of clients you are in a different kind of business, which doesn’t enjoy the benefits of the professional trader status.

Finally, as mentioned in the caution note previously, there is a formal process of paperwork and elections that must be made to the IRS in order to claim the professional trader status.