Maximizing the investment interest deduction.

• Author: Young, Patrick L.

Investment interest is interest paid or accrued on indebtedness incurred to purchase or carry property held for investment (Sec. 163(d)(3)(A)). Investment interest does not include qualified residence interest or interest incurred in a passive activity (Sec. 163(d)(3)(B)). However, if a passive activity generates portfolio income (interest, dividends, etc.), the portion of the passive activity interest expense allocable to the portfolio income is investment interest rather than passive activity interest (Notice 89-35; IRS Letter Ruling 9037027).

Property held for investment includes any property producing interest, dividends, annuities, royalties, and gain-generating property other than that used in a trade or business activity or passive activity. Investment property also includes an interest involving the conduct of a trade or business that is not considered a passive activity but in which the taxpayer does not materially participate (generally, oil and gas working interests in which the taxpayer does not materially participate) (Sec. 163(d)(5)). Income from these properties increases investment income, while deductions (including net losses from oil and gas working interests treated as investment property) related to them reduce investment income.

Taxpayers with oil and gas working interests must consider these rules if they are subject to investment interest expense limitations. If the taxpayer does not materially participate in the working interest, the net income or loss will impact investment income. Thus, taxpayers who do not materially participate in a working interest that generates a net loss must reduce their net investment income by the net loss. These taxpayers may benefit by taking steps that would allow them to meet the material participation standard for the activity so the net loss does not reduce their allowable investment interest expense.

Investment interest expense does not include interest expense that is capitalized (e.g., under Sec. 263A) or interest expense related to tax-exempt income that is not deductible under Sec. 265(a) (2). This rule also applies to mutual funds so that if a fund invests in both taxable and tax-exempt securities, the interest expense must be allocated proportionately based on the income from the fund. Prepaid interest on a margin account is generally not deductible in the year paid (unlike other itemized deductions, such as state income or real estate taxes); instead, it is carried forward and deducted in the year when it properly accrues (Sec. 461(g); Rev. Rul. 68-643, as modified by Rev. Rul. 69-582).

Interest expense incurred by a trader who materially participates in the trading activity is not subject to the investment interest expense limitations (King, 89 T.C. 445 (1987)). Whether a taxpayer is a trader or investor generally depends on the amount of trading activity and other factors.

If funds from a home-equity loan are used to purchase taxable investment securities, and the taxpayer has sufficient investment income to deduct the...