Investment interest expense and capital gain income.

• Author: Pearson, Mary Frances

In addition to imposing Sec. 1258, which recharacterizes gain from certain financial transactions, the Revenue Reconciliation Act of 1993 enacted another conversion transaction provision in Sec. 163(d)(4)(B)(i), to exclude the "net capital gain" from disposition of investment property from investment income in determining the usability of investment interest expense. However, a taxpayer can elect under Sec. 163(d)(4)(B)(iii) to take part of the net capital gain into account (as ordinary income) to offset investment expense for the current year and the carryover of suspended excess investment interest expenses from prior years.

Some commentators interpret the provision to require that a taxpayer treat the entire net capital gain from disposition of investment property as ordinary income. This interpretation appears erroneous. In effect, the taxpayer loses the benefit of the maximum capital gains rate under Sec. 1 (h) to the extent the taxpayer elects to treat the capital gain as ordinary income (since the incremental interest expense deduction produces only a 28% income tax benefit). In some cases the taxpayer might decide not to make the election and save the deduction for application against ordinary investment income in a future year that would be taxed at a higher marginal rate.

The wording of the "net gain attributable to the disposition of property held for investment" in Sec. 163(d)(4)(B)(ii) appears to mean capital gain attributable to dispositions of investment property during the current year, without regard to any net long-term (or short-term) capital gain carryover from prior years used in the current year.

This interpretation is supported by the provision's legislative history, which refers to the excess of net long-term capital gain over short-term capital loss "for the taxable year" and to the...