Maximizing Investment Expenses

Posted by Lee Reams Sr. on

Investment expenses are deducted from investment income when determining net investment income (NII). NII is used in two important tax computations: the 3.8% Sec 1411 tax on net investment income (NIIT) for higher-income taxpayers and the limitation on the deductibility of investment interest, Sec 163. Investment interest can only be deducted to the extent of gross investment income less allowable investment expenses. Therefore, it is important to understand what is classified as investment expenses for both computations.

CAUTION – Before any further discussion of investment expenses, everyone should be aware that some software programs only provide a single entry point for investment expenses under miscellaneous itemized deductions, and only the amounts included in that entry will be used in the computation of NIIT. Tax preparers with a single entry point need to overcome the habit of listing every expense separately and instead include them all in a single box. If backup is needed for the combined expenses, use a separate record. Preparers whose software allows them to tag items as investment expenses should be diligent in doing so.

“Investment expenses” are deductible expenses other than interest that are directly connected to the production of investment income but are limited to the amount allowed after the 2%-of-AGI floor. Investment income and expenses don’t include any amounts taken into account in computing income or loss from a passive activity (Code Sec. 163(d)(4)(D)). The following investment expenses and expenses for production or collection of income are deductible as itemized deductions:

  • Investment Interest – Entered on Schedule A under a special classification as investment interest. The amount deductible is limited to the NII (investment income less allowable investment expenses figured on IRS Form 4952).
  • Investment Taxes – A question is frequently raised about where to input property taxes on investment property, such as vacant land, to have those expenses included in the NII computation. If you have encountered that problem, by now you realize there is no entry point because property taxes are not included as an investment expense. Reg. Sec. 1.1411-4(f)(3)(iii) defines taxes allowed for computing NII as the taxes described in IRC Sec. 164(a)(3), which only include state and local taxes, foreign income taxes, war profits taxes, and excess profits taxes.  

The following investment expenses and expenses for production or collection of income are deductible as miscellaneous itemized deductions subject to the 2%-of-AGI floor.

  • Investment counsel or advisory fees (2015 Pub 529, Pg. 10).
  • Investment advisory publication subscriptions (2015 Pub 529, Pg. 10).
  • Investment expenses of buying, owning, and selling securities as an investor rather than as a trade or business (Fitzgerald, Raymond, (1956) TC Memo 1956-280, PH TCM ¶56280, 15 CCH TCM 1450). However, fees paid to a broker to purchase stocks or bonds increase the cost basis, and fees paid to a broker to sell stocks and bonds are a selling expense that reduces gain or increases a loss. These fees are not deductible as a miscellaneous deduction (2015 Pub 529, Pg. 9).
  • Dividend reinvestment-plan service charges (2015 Pub 529, Pg. 11).
  • Clerical help and office rent for managing investments and collecting income on them (2015 Pub 529, Pg. 10).
  • Depreciation on home computers that are used to produce income (for example, managing investments that produce taxable income) (2015 Pub 529, Pg. 9).
  • Fees to collect interest and dividends, such as fees paid to a broker, bank, trustee, or similar agent to collect taxable bond interest or dividends (2015 Pub 529, Pg. 9).
  • Allocable investment expenses of non-publicly offered mutual funds (2015 Pub 529, Pg. 10).
  • Losses on non-federally insured deposits in an insolvent or bankrupt financial institution. A taxpayer can elect (under Sec. 165(l)(5)(A)) to treat up to $20,000 in losses as an ordinary loss deductible as a tier II itemized investment deduction (2015 Pub 529, Pg. 10).
  • IRA trustee’s administrative fees that are separately billed and paid (2015 Pub 529, Pg. 11).
  • Custodial and trust administration fees (2015 Pub 529, Pg. 10). If the income generated by the account(s) to which the fee applies is partly nontaxable, the fee will have to be prorated. Deductible fee = total fee x (taxable income/total income). Deductible trust-administration fees for irrevocable trusts are already taken into account in determining the income reported on Schedule K-1 (Form 1041) issued to the trust beneficiary and cannot be deducted separately on the individual’s return. 
  • Safe deposit box rent (Reg § 1.67-1T(a)(1)(ii)), but only if the box is used to store taxable-income-producing stocks, bonds, or investment-related papers and documents (but not if the box is used for only jewelry or other personal items or for tax-exempt securities). (2015 Pub 529, Pg. 11)
  • Penalty on early withdrawal of savings ((Code Sec. 62(a)(9)) (Prop Reg § 1.1411-4(f)(2)(iii)))
  • Foreign taxes on investment income (Code Sec. 164(a)(3)). Caution: No double tax benefit. Must choose between itemized deduction and tax credit.
  • Investment-club expenses passed through to the investor but not those attributable to tax-free investments.

Only deductible in computing the 3.8% Sec 1411 tax on net investment income (NIIT) – Since the NIIT includes income from rentals and passive activities, the expenses allowed include the following, which are not allowed in computing the NII for the purposes of determining the allowable deduction for investment interest(Form 4952).

  • Expenses related to rental and royalty income and
  • State and local income taxes properly allocable to items included in NII

 Not Deductible as Investment Expenses:

  • Home Office - Home-office expenses allocable to “nonbusiness” investment activities aren’t deductible (Sec280A).
  • Property Taxes – Previously discussed.
  • Conventions & Seminars - Expenses of a convention, seminar, or similar meeting (e.g., day-trading courses) aren’t deductible. (Code Sec. 274(h)(7))
  • Stockholders’ Meetings - Travel and other expenses are not deductible, even if attending the meeting related to a decision to acquire stock in the company (2015 Pub 529, Pg. 16).
  • Tax-Exempt Income Expenses – Investment expenses related to producing tax-exempt income are not deductible (2015 Pub 529, Pg. 16).