Archive for the ‘investment income’ Tag

Back to Basics – Part XX – Form 4952 – Investment Interest Expense

Originally published in the Cedar Street Times

August 7, 2015

Today is my brother, Justin’s, birthday, and I know just what to get him.  We were both avid baseball card collectors from the time we were seven and eight years old on up through our middle school years.  Once, we even put on a “Kids Baseball Card Show” to buy, sell, and trade cards.  We went around advertising the show with flyers on telephone polls all over the local neighborhoods, and secured the neighborhood pool clubhouse facility to host our show.  It was a great success!

At the conclusion of my baseball card collecting career I had amassed over 10,000 cards with albums full of rookie cards and great players at the time.  One of my most prized cards was a 1954 Topps Willie Mays.  I remember wondering, how much money have I invested in all these cards over the years?  Would I be able to retire after selling the cards years later?  The Beckett Baseball Card Monthly price guide certainly made me think so based on the prices they listed and the rapid rates of increase.  Old cards from the 1940s – 1960s were worth hundreds or even thousands of dollars each.

A few years after my interest in card collecting waned, a mass of new brands flooded the markets.  That combined with other problems in baseball at the time sent the card market into an unrecoverable nose dive.  Over 20 years later, most cards are still worth a tiny fraction of their peak.

Although my desire was primarily the personal fun of collecting, there were many adult investors that had serious money in cards.  As with any investment bubble, I am sure there were collectors mortgaging their homes, running up credit card debt and borrowing from family in order to get a piece of the action.

As I reflect on that now, I see there would have been an opportunity for these people to take advantage of today’s topic – Form 4952 – Investment Interest Expense Deduction.   If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Investment interest expense is reported on Schedule A as an itemized deduction and is essentially interest paid on debt used to buy property that produces or hopefully will produce income at some point.  It doesn’t include interest expense incurred in your trade or business, or for passive activities like most rental properties.  These types of interest get reported elsewhere.  So, borrowing money to buy investments such as stocks, bonds, or annuities would qualify.  Many financial companies offer margin loans.  The interest on these loans would certainly qualify as investment interest expense if the proceeds were used to buy more stocks and bonds.  Borrowing money to buy the right to royalty income or to buy property held for investment gain, such as vacant land, art, or even baseball cards would also qualify, among other things.

Due to passive activity rules which limit or even eliminate current deductions on passive rental activities such as a home you rent out, many people would like to be able to deduct the interest as investment interest instead.  However, interest on passive activities is specifically excluded from being classified as investment interest expense.  The interest on vacant land can usually escape this clause, even if small amounts of rent are collected since the rent is incidental to the paramount investment purpose of appreciation.  To be considered incidental, the principal purpose must be to realize gain from appreciation AND the gross rents received for the year must be less than two percent of the lesser of the property’s unadjusted basis or its fair market value.

The rub with investment interest expense is that it is only deductible to the extent that you have investment income!  If you have no investment income, you can’t deduct the expense, and it gets suspended until a year you actually do have investment income.  So what qualifies as investment income?  Well, all of the things we just discussed for which you borrowed  money and can deduct as investment interest expense – so interest, dividends, gains from property held for investment, etc.  Prior to being applied against investment interest expense, the investment income figure is reduced by other investment expenses that you may have reported on Schedule A – such as investment advisory fees, safe deposit boxes, investment subscriptions, etc.

By default, your net capital gains (meaning net long-term capital gains in excess of net short-term capital losses) as well as qualified dividends are not included in investment income.  This is done because both of these already get taxed at favorable lower capital gains rates, so the thinking is, “Why would you want to waste a deduction to offset income that is already getting a lower capital gains rate, when you could instead use it to offset ordinary income taxed at higher rates ?”  The answer is that sometimes you may not be able to ever foresee having much ordinary investment income taxable at higher rates.  And instead of just suspending the deduction and getting n0 current tax benefit, you elect to include your net capital gains and qualified dividends as investment income and use the deduction to help wipe that income out, thus saving you current taxes.

The Form 4952 itself is a rather simple form – only a half page in length.  Part I is a summary of the gross investment interest expense including any current interest and past interest that was carried over.  Part II helps you calculate the net investment income  from interest dividends, gains, capital gains, less investment expenses from Schedule A.  Part III compares parts I and II and calculates the investment interest expense that will be currently deductible, as well as the part that is being suspended to the future if there is not enough investment income to absorb the expenses.

As for the card collecting Justin and I did, I sure am glad we didn’t go into debt buying baseball cards and having to file 4952s! Now about that gift – how about a box of wax packs or a factory sealed set – I know just where to get them…

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back to Basics Part IV – Even More Sch. A

Originally published in the Cedar Street Times

November  28, 2014

In this issue, we are continuing our discussion on Schedule A – Itemized Deductions.  Prior articles are republished on my website at www.tlongcpa.com/blog if you would like to catch up on our Back to Basics series on personal tax returns.

The third section on Schedule A covers deductible interest you have paid.  For most people the big item here is the mortgage interest on their principal residence.  You can also deduct mortgage interest on one other personal residence as well.  A lot of people assume that if the interest shows up on a Form 1098 that it is deductible.  Contrary to popular belief, that does not determine deductibility.  People with rental and personal properties, for instance, that refinance and pull money out of one property and put it into another are especially at risk of having made a major mistake.

The home mortgage interest deduction requires the debt to be secured by a qualified home and have been used to acquire, construct, or improve the home up to $1,000,000 of debt and up to $100,000 of additional debt for any purpose.  Assume someone refinances a rental property and pulls $200,000 out of it to buy a personal residence.  The interest on the $200,000 is not a rental property deduction on Schedule E because the funds did not go into the rental property activity.  It is also not deductible on Schedule A as home mortgage interest because the debt is not secured by a qualified personal residence – it is secured by the rental property!  Oops – nondeductible personal interest!  There are some work-arounds to this, but they are not always easily accomplished, and the problem is more likely to be found in an audit when it is too late.

Another common problem crops up for people on personal residences who take out a second loan, open a line of credit, or do a cash-out refinance and do not use the cash to improve the home.  This portion is called home equity debt.  You can only deduct the interest on up to $100,000 of total home equity debt.  Anything beyond that becomes non-deductible personal interest, and would need to be tracked properly.  If you later refinance your primary loan and the home equity loan into one loan, the character of the debt remains the same.  This means you have to keep track of the portion of the debt that is home equity debt versus acquisition debt that comprises the one loan.

Other deductible interest would include points paid during a purchase or refinance.  Often these are not included on the 1098 and you must look to the escrow closing statement to pick them up.  New purchases allow 100% deduction of the points in the year purchased.  Refinances, require amortizing and taking a portion of the deduction each year over the life of the loan term.  Private Mortgage Insurance (PMI) used to be deductible as interest, subject to limitations, but is not currently slated for a deduction in 2014.  Investment interest is another item that falls into this section of Schedule A.  A simple example would be borrowing money to invest in the stock market – like a margin loan.  However, investment interest expense is only deductible to the extent that you have investment income (Form 4952).  So, if you paid $1,000 of interest, you better have made a $1,000 of investment income, otherwise the excess gets suspended and carried forward for the future.

The fourth section on Schedule A deals with gifts to charity.  Volumes have been written on this topic!  Gifts to charity must be made to qualifying organizations for U.S. tax purposes.  There is a 50 percent of your adjusted gross income limit each year regarding regular donations to charities.  There are also 30 percent and 20 percent limitations for donations to certain types of organizations and types of property donated.  So if you gave a very large gift, it could get suspended and carried over to the future.  There is generally a five-year carryover limit, at which point any remaining deductions would be lost.

All donations must have substantiation, no matter how small.  Cash donations under $250 must be substantiated with a properly worded letter from the organization, a cancelled check, a bank statement, or a credit card statement.  Cash donations over $250 require a letter from the organization.  Noncash donations have a lot of rules.  Every noncash donation requires a receipt from the organization.  Noncash donations over $500 require the filing of an 8283.  Noncash donations over $5,000 require a qualified appraisal as well.  It would be in your best interest to ensure you have properly planned when making (or anticipating to make) a donation over $5,000.  The $5,000 threshold is cumulative throughout the year for similar items.  This means that many trips throughout the year of donating to the local charitable thrift store of household goods would retroactively require an appraisal to claim over $5,000.  And it is hard to appraise items you no longer have!  As you can see there can be much to consider.

You can deduct out-of-pocket charitable volunteer expenses such as uniforms or gear necessary for the volunteer work.  If you travel on your own dime overnight, and you have substantial duties and very little personal activities, you may be able to deduct airline tickets, meals, lodging, etc.  Volunteer excursions that are not away from home overnight do not qualify for meal deductions.  If you use your vehicle for charitable purposes you can deduct the mileage at 14 cents per mile, or track gas and oil expenses.

A few things that are definitely not deductible but are commonly misunderstood by individuals as well as by small charitable organizations: 1) gifts to needy or worthy individuals –  even if you give to a qualified organization be sure you do not earmark your donation for a particular person or family, or your deduction is not legitimate ,  2) gifts of your time or services – like the artist trying to deduct a self-created painting at “fair market value” – you can only deduct hard costs such as the canvas and paint costs.  Since you never included in income and paid tax on your services, you cannot take a deduction for them,  3) charity raffles, bingo, lotteries  4) charitable auctions or other donations to the extent of the value you received in return – such as paying $75 in a charity silent auction, but you get a $100 gift certificate – no deduction allowed.  Or the local public radio station sends you a set of CDs they value at $100 in return for your $125 donation – you only get to deduct $25.

In two weeks we will continue our discussion regarding Schedule A.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.