Publication 550
Investment Income and Expenses

(Including Capital Gains and Losses)

For use in preparing 2002 Returns

3. Investment Expenses

• At-risk rules
• Passive activity
• Portfolio income

Topics

This chapter discusses:

• Limits on deductions,
• Interest expenses,
• Bond premium amortization,
• Expenses of producing income,
• Nondeductible expenses, and
• How to report investment expenses.

Useful Items

You may want to see:

Publication

• 535   Business Expenses
• 925   Passive Activity and At-Risk Rules
• 929   Tax Rules for Children and Dependents

Form (and Instructions)

• Schedule A (Form 1040)   Itemized Deductions
• 4952   Investment Interest Expense Deduction

See chapter 5 for information about getting these publications and forms.

Limits on Deductions

Your deductions for investment expenses may be limited by:

• The at-risk rules,
• The passive activity loss limits,
• The limit on investment interest, or
• The 2% limit on certain miscellaneous itemized deductions.

The at-risk rules and passive activity rules are explained briefly in this section. The limit on investment interest is explained later in this chapter under Interest Expenses. The 2% limit is explained later in this chapter under Expenses of Producing Income.

At-risk rules.   Special at-risk rules apply to most income-producing activities. These rules limit the amount of loss you can deduct to the amount you risk losing in the activity. Generally, this is the amount of cash and the adjusted basis of property you contribute to the activity. It also includes money you borrow for use in the activity if you are personally liable for repayment or if you use property not used in the activity as security for the loan. For more information, see Publication 925.

Passive activity losses and credits.   The amount of losses and tax credits you can claim from passive activities is limited. Generally, you are allowed to deduct passive activity losses only up to the amount of your passive activity income. Also, you can use credits from passive activities only against tax on the income from passive activities. There are exceptions for certain activities, such as rental real estate activities.

Passive activity.   A passive activity generally is any activity involving the conduct of any trade or business in which you do not materially participate and any rental activity. However, if you are involved in renting real estate, the activity is not a passive activity if both of the following are true.

1. More than one-half of the personal services you perform during the year in all trades or businesses are performed in real property trades or businesses in which you materially participate.
2. You perform more than 750 hours of services during the year in real property trades or businesses in which you materially participate.

The term trade or business generally means any activity that involves the conduct of a trade or business, is conducted in anticipation of starting a trade or business, or involves certain research or experimental expenditures. However, it does not include rental activities or certain activities treated as incidental to holding property for investment.

You are considered to materially participate in an activity if you are involved on a regular, continuous, and substantial basis in the operations of the activity.

Other income (nonpassive income).   Generally, you can use losses from passive activities only to offset income from passive activities. You generally cannot use passive activity losses to offset your other income, such as your wages or your portfolio income. Portfolio income includes gross income from interest, dividends, annuities, or royalties that is not derived in the ordinary course of a trade or business. It also includes gains or losses (not derived in the ordinary course of a trade or business) from the sale or trade of property (other than an interest in a passive activity) producing portfolio income or held for investment. This includes capital gain distributions from mutual funds and real estate investment trusts.

You cannot use passive activity losses to offset Alaska Permanent Fund dividends.

Expenses.   Do not include in the computation of your passive activity income or loss:

1. Expenses (other than interest) that are clearly and directly allocable to your portfolio income, or
2. Interest expense properly allocable to portfolio income.

However, this interest and other expenses may be subject to other limits. These limits are explained in the rest of this chapter.

Additional information.   For more information about determining and reporting income and losses from passive activities, see Publication 925.

Interest Expenses

This section discusses interest expenses you may be able to deduct as an investor.

For information on business interest, see chapter 5 of Publication 535.

You cannot deduct personal interest expenses other than qualified home mortgage interest, as explained in Publication 936, Home Mortgage Interest Deduction, and interest on certain student loans, as explained in Publication 970, Tax Benefits for Education.

Investment Interest

If you borrow money to buy property you hold for investment, the interest you pay is investment interest. You can deduct investment interest subject to the limit discussed later. However, you cannot deduct interest you incurred to produce tax-exempt income. See Tax-exempt income under Nondeductible Expenses, later. Nor can you deduct interest expenses on straddles, also discussed under Nondeductible Expenses.

Investment interest does not include any qualified home mortgage interest or any interest taken into account in computing income or loss from a passive activity.

Investment property.   Property held for investment includes property that produces interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. It also includes property that produces gain or loss (not derived in the ordinary course of a trade or business) from the sale or trade of property producing these types of income or held for investment (other than an interest in a passive activity). Investment property also includes an interest in a trade or business activity in which you did not materially participate (other than a passive activity).

Partners, shareholders, and beneficiaries.   To determine your investment interest, combine your share of investment interest from a partnership, S corporation, estate, or trust with your other investment interest.

Allocation of Interest Expense

If you borrow money for business or personal purposes as well as for investment, you must allocate the debt among those purposes. Only the interest expense on the part of the debt used for investment purposes is treated as investment interest. The allocation is not affected by the use of property that secures the debt.

Example 1.   You borrow $10,000 and use $8,000 to buy stock. You use the other $2,000 to buy items for your home. Since 80% of the debt is used for, and allocated to, investment purposes, 80% of the interest on that debt is investment interest. The other 20% is nondeductible personal interest.

Debt proceeds received in cash.   If you receive debt proceeds in cash, the proceeds are generally not treated as investment property.

Debt proceeds deposited in account.   If you deposit debt proceeds in an account, that deposit is treated as investment property, regardless of whether the account bears interest. But, if you withdraw the funds and use them for another purpose, you must reallocate the debt to determine the amount considered to be for investment purposes.

Example 2.   Assume in Example 1 that you borrowed the money on March 1 and immediately bought the stock for $8,000. You did not buy the household items until June 1. You had deposited the $2,000 in the bank. You had no other transactions on the bank account and made no principal payments on the debt. The $2,000 is treated as being used for an investment purpose for the 3-month period. Your total interest expense for 3 months on this debt is investment interest. In June, you must begin to allocate 80% of the debt and the interest expense to investment purposes and 20% to personal purposes.

Amounts paid within 30 days.    If you receive loan proceeds in cash or if the loan proceeds are deposited in an account, you can treat any payment (up to the amount of the proceeds) made from any account you own, or from cash, as made from those proceeds. This applies to any payment made within 30 days before or after the proceeds are received in cash or deposited in your account.

If you received the loan proceeds in cash, you can treat the payment as made on the date you received the cash instead of the date you actually made the payment.

Payments on debt may require new allocation.   As you repay a debt used for more than one purpose, you must reallocate the balance. You must first reduce the amount allocated to personal purposes by the repayment. You then reallocate the rest of the debt to find what part is for investment purposes.

Example 3.   If, in Example 2, you repay $500 on November 1, the entire repayment is applied against the amount allocated to personal purposes. The debt balance is now allocated as $8,000 for investment purposes, and $1,500 for personal purposes. Until the next reallocation is necessary, 84% ($8,000 ÷ $9,500) of the debt and the interest expense is allocated to investment.

Pass-through entities.   If you use borrowed funds to buy an interest in a partnership or S corporation, then the interest on those funds must be allocated based on the assets of the entity. If you contribute to the capital of the entity, you can make the allocation using any reasonable method.

Additional allocation rules.   For more information about allocating interest expense, see chapter 5 of Publication 535.

When To Deduct
Investment Interest

If you use the cash method of accounting, you must pay the interest before you can deduct it.

If you use an accrual method of accounting, you can deduct interest over the period it accrues, regardless of when you pay it. For an exception, see Unpaid expenses owed to related party under When To Report Investment Expenses, later in this chapter.

Example.   You borrowed $1,000 on September 6, 2002, payable in 90 days at 12% interest. On December 5, 2002, you paid this with a new note for $1,030, due on March 5, 2003. If you use the cash method of accounting, you cannot deduct any part of the $30 interest on your return for 2002 because you did not actually pay it. If you use an accrual method, you may be able to deduct a portion of the interest on the loans through December 31, 2002, on your return for 2002.

Interest paid in advance.   Generally, if you pay interest in advance for a period that goes beyond the end of the tax year, you must spread the interest over the tax years to which it belongs under the OID rules. You can deduct in each year only the interest for that year.

Interest on margin accounts.   If you are a cash method taxpayer, you can deduct interest on margin accounts to buy taxable securities as investment interest in the year you paid it. You are considered to have paid interest on these accounts only when you actually pay the broker or when payment becomes available to the broker through your account. Payment may become available to the broker through your account when the broker collects dividends or interest for your account, or sells securities held for you or received from you.

You cannot deduct any interest on money borrowed for personal reasons.

Deferral of interest deduction for market discount bonds.   The amount you can deduct for interest expense you paid or accrued during the year to buy or carry a market discount bond may be limited. This limit does not apply if you accrue the market discount and include it in your income currently.

Under this limit, the interest is deductible only to the extent it is more than:

1. The total interest and OID includible in gross income for the bond for the year, plus
2. The market discount for the number of days you held the bond during the year.

Figure the amount in (2) above using the rules for figuring accrued market discount in chapter 1 under Market Discount Bonds.

Disallowed interest expense.   In the year you dispose of the bond, you can deduct the amount of any interest expense you were not allowed to deduct in earlier years.

Choosing to deduct disallowed interest expense before the year of disposition.   You can choose to deduct disallowed interest expense in any year before the year you dispose of the bond, up to your net interest income from the bond during the year. The rest of the disallowed interest expense remains deductible in the year you dispose of the bond.

Net interest income.   This is the interest income (including OID) from the bond that you include in income for the year, minus the interest expense paid or accrued during the year to purchase or carry the bond.

Deferral of interest deduction for short-term obligations.   If the current income inclusion rules discussed in chapter 1 under Discount on Short-Term Obligations do not apply to you, the amount you can deduct for interest expense you paid or accrued during the year to buy or carry a short-term obligation is limited.

The interest is deductible only to the extent it is more than:

1. The amount of acquisition discount or OID on the obligation for the tax year, plus
2. The amount of any interest payable on the obligation for the year that is not included in income because of your accounting method (other than interest taken into account in determining the amount of acquisition discount or OID).

The method of determining acquisition discount and OID for short-term obligations is discussed in chapter 1 under Discount on Short-Term Obligations.

Disallowed interest expense.   In the year you dispose of the obligation, or if you choose, in another year in which you have net interest income from the obligation, you can deduct the amount of any interest expense you were not allowed to deduct for an earlier year. Follow the same rules provided in the earlier discussion under Deferral of interest deduction for market discount bonds.

Limit on Deduction

Generally, your deduction for investment interest expense is limited to the amount of your net investment income.

You can carry over the amount of investment interest that you could not deduct because of this limit to the next tax year. The interest carried over is treated as investment interest paid or accrued in that next year.

You can carry over disallowed investment interest to the next tax year even if it is more than your taxable income in the year the interest was paid or accrued.

Net Investment Income

Determine the amount of your net investment income by subtracting your investment expenses (other than interest expense) from your investment income.

Investment income.   This generally includes your gross income from property held for investment (such as interest, dividends, annuities, and royalties). Investment income does not include Alaska Permanent Fund dividends.

Choosing to include net capital gain.   Investment income generally does not include net capital gain from disposing of investment property (including capital gain distributions from mutual funds). However, you can choose to include all or part of your net capital gain in investment income.

You make this choice by completing line 4e of Form 4952 according to its instructions.

If you choose to include any amount of your net capital gain in investment income, you must reduce your net capital gain that is eligible for the lower capital gains tax rates by the same amount.

For more information about the capital gains rates, see Capital Gain Tax Rates in chapter 4.

Before making this choice, consider the overall effect on your tax liability. Compare your tax if you make this choice with your tax if you do not.

Investment income of child reported on parent's return.   Investment income includes the part of your child's interest and dividend income that you choose to report on your return. If the child does not have Alaska Permanent Fund dividends or capital gain distributions, this is the amount on line 6 of Form 8814, Parents' Election To Report Child's Interest and Dividends. Include it on line 4a of Form 4952.

Example.   Your 8-year-old son has interest income of $2,000, which you choose to report on your own return. You enter $2,000 on lines 1a and 4 of Form 8814 and $500 on line 6 of Form 8814 and line 21 of Form 1040. Your investment income includes this $500.

Child's Alaska Permanent Fund dividends.   If part of the amount you report is your child's Alaska Permanent Fund dividends, that part does not count as investment income. To figure the amount of your child's income that you can consider your investment income, start with the amount on line 6 of Form 8814. Multiply that amount by a percentage that is equal to the Alaska Permanent Fund dividends divided by the total amount of interest and dividend income on lines 1a and 2 of Form 8814. Subtract the result from the amount on line 6 of Form 8814.

Example.   Your 10-year-old child has taxable interest income of $4,000 and Alaska Permanent Fund dividends of $2,000. You choose to report this on your return. You enter $4,000 on line 1a of Form 8814, $2,000 on line 2, and $6,000 on line 4. You then enter $4,500 on line 6 of Form 8814 and line 21 of Form 1040. You figure the amount of your child's income that you can consider your investment income as follows: