Investment interest expense and capital gain income.

In addition to imposing Sec. 1258, which recharacterizes gain from certain financial transactions, the Revenue Reconciliation Act of 1993 enacted another conversion transaction provision in Sec. 163(d)(4)(B)(i), to exclude the "net capital gain" from disposition of investment property from investment income in determining the usability of investment interest expense. However, a taxpayer can elect under Sec. 163(d)(4)(B)(iii) to take part of the net capital gain into account (as ordinary income) to offset investment expense for the current year and the carryover of suspended excess investment interest expenses from prior years.

Some commentators interpret the provision to require that a taxpayer treat the entire net capital gain from disposition of investment property as ordinary income. This interpretation appears erroneous. In effect, the taxpayer loses the benefit of the maximum capital gains rate under Sec. 1 (h) to the extent the taxpayer elects to treat the capital gain as ordinary income (since the incremental interest expense deduction produces only a 28% income tax benefit). In some cases the taxpayer might decide not to make the election and save the deduction for application against ordinary investment income in a future year that would be taxed at a higher marginal rate.

The wording of the "net gain attributable to the disposition of property held for investment" in Sec. 163(d)(4)(B)(ii) appears to mean capital gain attributable to dispositions of investment property during the current year, without regard to any net long-term (or short-term) capital gain carryover from prior years used in the current year.

This interpretation is supported by the provision's legislative history, which refers to the excess of net long-term capital gain over short-term capital loss "for the taxable year" and to the limit on the long-term capital gain deduction in Sec. 1202 when investment interest expense has been taken.

The Conference Report to the Tax Reform Act of 1969 explained that investment interest expense (in excess of $25,000 under former law) is first offset against net investment income and then against long-term capital gain income (before the 50% capital gains deduction, which is reduced by the amount of investment interest expense that offsets capital gains). This provision was modified to adjust the carryover of excess investment interest expense that may not be currently deducted, since the capital gain deduction allowable in subsequent years reduces the amount of any further carryover.

Interestingly, the Conference Report went on to explain that "[c]apital gains which are used to offset investment interest are treated as ordinary income for purposes of the alternative capital gains tax, the capital gains deduction and the minimum tax for tax preferences" (under former law). The legislative history suggests the purpose of Sec. 163(d) was to prevent a current year mismatch of investment interest expense against capital gains. Furthermore, Letter Ruling (TAM) 9307005 liberally interpreted investment income to include interest received on a Federal income tax refund.

In summary, a taxpayer should be allowed to deduct investment interest expense against the portion of the net long-term capital gain (unreduced by capital loss carryovers from previous years) elected by the taxpayer to be treated as ordinary investment income.