Publication 550
Investment Income and Expenses

(Including Capital Gains and Losses)

For use in preparing 2002 Returns

Nondeductible Expenses

Some expenses that you incur as an investor are not deductible.

Stockholders' meetings.   You cannot deduct transportation and other expenses that you pay to attend stockholders' meetings of companies in which you have no interest other than owning stock. This is true even if your purpose in attending is to get information that would be useful in making further investments.

Investment-related seminar.   You cannot deduct expenses for attending a convention, seminar, or similar meeting for investment purposes.

Single-premium life insurance, endowment, and annuity contracts.   You cannot deduct interest on money you borrow to buy or carry a single-premium life insurance, endowment, or annuity contract.

Used as collateral.   If you use a single premium annuity contract as collateral to obtain or continue a mortgage loan, you cannot deduct any interest on the loan that is collateralized by the annuity contract. Figure the amount of interest expense disallowed by multiplying the current interest rate on the mortgage loan by the lesser of the amount of the annuity contract used as collateral or the amount of the loan.

Borrowing on insurance.   Generally, you cannot deduct interest on money you borrow to buy or carry a life insurance, endowment, or annuity contract if you plan to systematically borrow part or all of the increases in the cash value of the contract. This rule applies to the interest on the total amount borrowed to buy or carry the contract, not just the interest on the borrowed increases in the cash value.

Tax-exempt income.   You cannot deduct expenses you incur to produce tax-exempt income. Nor can you deduct interest on money you borrow to buy tax-exempt securities or shares in a regulated investment company (mutual fund) that distributes only exempt-interest dividends.

Short-sale expenses.   The rule disallowing a deduction for interest expenses on tax-exempt securities applies to amounts you pay in connection with personal property used in a short sale or amounts paid by others for the use of any collateral in connection with the short sale. However, it does not apply to the expenses you incur if you deposit cash as collateral for the property used in the short sale and the cash does not earn a material return during the period of the sale. Short sales are discussed in chapter 4.

Expenses for both tax-exempt and taxable income.   You may have expenses that are for both tax-exempt and taxable income. If you cannot specifically identify what part of the expenses is for each type of income, you can divide the expenses, using reasonable proportions based on facts and circumstances. You must attach a statement to your return showing how you divided the expenses and stating that each deduction claimed is not based on tax-exempt income.

One accepted method for dividing expenses is to do it in the same proportion that each type of income is to the total income. If the expenses relate in part to capital gains and losses, include the gains, but not the losses, in figuring this proportion. To find the part of the expenses that is for the tax-exempt income, divide your tax-exempt income by the total income and multiply your expenses by the result.

Example.   You received $6,000 interest; $4,800 was tax-exempt and $1,200 was taxable. In earning this income, you had $500 of expenses. You cannot specifically identify the amount of each expense item that is for each income item, so you must divide your expenses. 80% ($4,800 tax-exempt interest divided by $6,000 total interest) of your expenses is for the tax-exempt income. You cannot deduct $400 (80% of $500) of the expenses. You can deduct $100 (the rest of the expenses) because they are for the taxable interest.

State income taxes.   If you itemize your deductions, you can deduct, as taxes, state income taxes on interest income that is exempt from federal income tax. But you cannot deduct, as either taxes or investment expenses, state income taxes on other exempt income.

Interest expense and carrying charges on straddles.   You cannot deduct interest and carrying charges that are allocable to personal property that is part of a straddle. The nondeductible interest and carrying charges are added to the basis of the straddle property. However, this treatment does not apply if:

1. All the offsetting positions making up the straddle either consist of one or more qualified covered call options and the optioned stock or consist of section 1256 contracts (and the straddle is not part of a larger straddle), or
2. The straddle is a hedging transaction.

For information about straddles, including definitions of the terms used in this discussion, see chapter 4.

Interest includes any amount you pay or incur in connection with personal property used in a short sale. However, you must first apply the rules discussed in Short Sale Expenses under Short Sales in chapter 4.

To determine the interest on market discount bonds and short-term obligations that are part of a straddle, you must first apply the rules discussed under Deferral of interest deduction for market discount bonds and Deferral of interest deduction for short-term obligations (both under Interest Expenses, earlier).

Nondeductible amount.   Figure the nondeductible amount of interest and carrying charges on straddle property as follows.

1. Add:
   1. Interest on indebtedness incurred or continued to buy or carry the personal property, and
   2. All other amounts (including charges to insure, store, or transport the personal property) paid or incurred to carry the personal property.
2. Subtract from the amount in (1):
   1. Interest (including OID) includible in gross income for the year on the personal property,
   2. Any income from the personal property treated as ordinary income on the disposition of short-term government obligations or as ordinary income under the market discount and short-term bond provisions - see Discount on Debt Instruments in chapter 1,
   3. The dividends includible in gross income for the year from the personal property, and
   4. Any payment on a loan of the personal property for use in a short sale that is includible in gross income.

Basis adjustment.   Add the nondeductible amount to the basis of your straddle property.

How To Report
Investment Expenses

To deduct your investment expenses, you must itemize deductions on Schedule A (Form 1040). Enter your deductible investment interest expense on line 13, Schedule A. Include any deductible short sale expenses. (See Short Sales in chapter 4 for information on these expenses.) Also attach a completed Form 4952 if you used that form to figure your investment interest expense.

Enter the total amount of your other investment expenses (other than interest expenses) on line 22, Schedule A. List the type and amount of each expense on the dotted lines next to line 22. (If necessary, you can show the required information on an attached statement.) Include the total on line 23 with your other miscellaneous deductions that are subject to the 2% limit.

For information on how to report amortizable bond premium, see Bond Premium Amortization, earlier in this chapter.

When To Report Investment Expenses

If you use the cash method to report income and expenses, you generally deduct your expenses, except for certain prepaid interest, in the year you pay them.

If you use an accrual method, you generally deduct your expenses when you incur a liability for them, rather than when you pay them.

Also see When To Deduct Investment Interest, earlier in this chapter.

Unpaid expenses owed to related party.   If you use an accrual method, you cannot deduct interest and other expenses owed to a related cash-basis person until payment is made and the amount is includible in the gross income of that person. The relationship, for purposes of this rule, is determined as of the end of the tax year for which the interest or expense would otherwise be deductible. If a deduction is denied under this rule, this rule will continue to apply even if your relationship with the person ceases to exist before the amount is includible in the gross income of that person.

This rule generally applies to those relationships listed in chapter 4 under Related Party Transactions. It also applies to accruals by partnerships to partners, partners to partnerships, shareholders to S corporations, and S corporations to shareholders.

The postponement of deductions for unpaid expenses and interest under the related party rule does not apply to original issue discount (OID), regardless of when payment is made. This rule also does not apply to loans with below-market interest rates or to certain payments for the use of property and services when the lender or recipient has to include payments periodically in income, even if a payment has not been made.

Illustrated Form 4952

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