Deducting interest expense: the party's over (for some).

Taxpayers often borrow money to invest. If the interest payments on a loan are large relative to the income generated by an investment, significant tax benefits can result. For example, investors with high incomes can defer taxes by investing in growth-oriented stocks and still get a current interest expense deduction. However, the investment interest expense deduction is limited to a taxpayer's net investment income for the year.

Net investment income is the excess of a taxpayer's investment income over investment expenses. Investment income includes dividends, interest, annuities and royalties. Investment expenses are those deductible expenses directly connected with the production of investment income, such as safe-deposit box rentals, financial adviser fees and subscriptions to financial journals. Investment expenses, however, don't include interest paid on a loan.

Suppose Jean is in the 36% bracket and borrows $50,000 at 10% to invest in various stocks. On receiving dividends of $6,000, Jean can deduct $5,000 ($50,000 x 10%) of the interest expense. But if the $50,000 is invested in growth stocks that pay only $500 in dividends, current deductions are limited to the net investment income of $500; the remaining interest expense of $4,500 must be carried forward indefinitely.

In earlier years Jean might have solved this problem by selling enough stock to yield a long-term capital gain of $4,500. Under rules in effect before 1993, investment income included not only gross income from property held for investment but also any net gain attributable to the disposition of the property. Thus, in 1992 Jean could have deducted the full $5,000 of investment interest and at the same time limited the tax on net capital gain to 28%. Talk about having your cake and eating it too!

Beginning in 1993, however, net capital gains from the disposition of investment property no longer are included in the definition of investment income when determining the limit on the investment interest expense deduction.

But the news isn't all grim. A new special election, hidden in the Omnibus Budget Reconciliation Act of 1993 (OBRA), permits taxpayers to include net capital gains in investment income if they agree to forgo the benefit of the 28% maximum capital gains rate on the included amount.

Jean now has a choice: (1) to currently deduct $500 of interest expense and carry the balance forward indefinitely (in which case the long-term capital gain would be taxed at 28%) or (2) to elect to treat the capital gain as investment income and deduct the full $5,000 of interest expense (which would mean losing the benefit of the lower 28% bracket).

Observation: In deciding whether to make this special election, taxpayers with marginal rates above 28% must compare the cost of deferring the interest deduction to a future year with the cost of losing the lower 28% tax on capital gains. Taxpayers whose marginal rate is 28% or lower have nothing to lose by making the election and may party on.