Treating qualified dividends as investment income.

The Service has issued final regulations (TD 9191) explaining how noncorporate taxpayers may elect to treat qualified dividend income as investment income when computing the investment interest deduction.

Overview: The investment interest a noncorporate taxpayer may deduct in any tax year is generally limited by Sec. 163(d)(1) to "net investment income" for the year. Net investment income does not include "qualified dividends" (i.e., dividends taxed at a top 5% or 15% rate under Sec. 1(h)(11)). However, a taxpayer may choose under Sec. 163(d)(4)(B) to treat qualified dividends as investment income for purposes of the investment income deduction. If the taxpayer makes the election, qualified dividends are taxed as ordinary income, but may be offset by investment interest.

The qualified dividend preferential rates and election were created by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), which also lowered the top rate on adjusted net capital gain to 5% or 15%. Even before the JGTRRA's enactment, the Code contained a similar election for net capital gain. Under this rule, which is also contained in Sec. 163(d)(4)(B), net capital gain is not included in investment income and, thus, does not help increase a taxpayer's deduction for investment interest unless the taxpayer elects to treat net capital gain as investment income.

New rules: Now, under Regs. Sec. 1.163(d)-1(b), the election to treat qualified dividends as investment income is made in the same way as the one to treat net capital gain as investment income, on Form 4952, Investment Interest Expense Deduction.

Under Regs. Sec. 1.163(d)-1(d), the election applies to tax years beginning after 2002 and before 2009. According to Regs. Sec. 1.163(d)-1(c), once made, the election is revocable only with the Service's consent. The rules were effective March 18, 2005.