As a common person, an entrepreneur or otherwise, you may invest in several areas but may not have enough knowledge about the taxation factor. All types of investments are made with intent to earn interest and dividends and therefore it by default becomes a source of income and thereby tax deductible. Knowing the key points will help you to avoid tax issues and other legal obligations.
Laws as it is, especially tax laws, change frequently, and recently there are a few specific changes brought in regarding investment-related expenses. These are no longer deductible provided you itemize them appropriately.
Assuming that you have borrowed money and incurred debt to purchase taxable investments, there are ways in which you can reduce the taxable income on your investments. For this, you will need to use the expenses on the interest of your loans.
Moreover, if you incur capital losses to the tune of up to $3,000, you can use it as an effective tool to counterweigh your normal taxable income, according to IRS.
Rights of taxpayers
The IRS has formulated specific right for taxpayers that you must follow and use to reduce your tax burden, especially if you have to work on your debt strategically and efficiently.
- As a taxpayer, you are allowed to enjoy numerous tax deductions for your investment-related expenses provided these expenses produce income that is taxable.
- In addition to that, the Tax Cuts and Jobs Act or TCJA has also brought in some changes in the rules related to the deductions related to investment expenses.
Therefore, it is required that you itemize these deductions on file for annual tax returns. For this, you will have to be up to date on such changes so that you do not miss out any significant deduction that could have benefited you. Your aim should be at maximizing your tax deductions to reduce your tax burden significantly.
Common deductible expenses
Here are a few common investment expenses that are deductible according to tax laws and the ways in which these can reduce your final taxable income.
Miscellaneous investment-related expenses are no more exempted from deductions as it was before the passage of TCJA under the head “miscellaneous itemized deductions.” These itemized deductions included specific expenses like custodial fees for IRA, fees for investment advice, and accounting costs related to collect or produce taxable income. However, many investors believed that these deductions did not actually provide any tax benefit to them. This is due to the specific limitations in the old tax system code before the TCJA. The main three limitations that caused people loss of a part or their entire deductions are:
- The 2% adjusted gross income – This AGI limitation on the itemized miscellaneous deductions required it to be more than 2% of the AGI to receive any tax benefit.
- The 3% Pease limitation – This limitation reduced the itemized miscellaneous deductions overall once the taxpayer got a definite amount of income.
- The alternative minimum tax – The AMT came into play when the income, as well as the deduction of the taxpayer, was too large. This resulted in a part or entire itemized deductions.
Such limitations made the taxpayers think that they had gotten a deduction, but in reality, they had seen a limited benefit or had lost it all.
This meant that it did not have any significant effect on their debts to make investments and most of the investors had to consider alternative sources of income to deal with their debts. Few even consulted debt advisories to know more about debt consolidation and went through debt consolidation reviews for that matter.
Investment Interest Expense
It is essential to know at this point that, consolidating only one or a couple of changes in tax laws are not enough to see the effect of it on your debt investment. Instead, you must look at the changes collectively to understand the significance and ramifications these might have on your income.
You must consider the changes in new tax rates and brackets as well. If you are unsure about the loss in investment interest expenses and loss of itemized miscellaneous deductions, make sure that you talk to your tax advisor.
The expert advisor will tell you that if you itemize your miscellaneous deductions, you may be eligible to claim for deduction for the interest expenses on your investments. These are the interest paid on the debt you have incurred to purchase taxable investment instruments.
This may even include the margin loans that you use to buy stock in your brokerage account. However, the deduction of interest is not applicable if you use the loan to purchase any tax-advantaged funds such as municipal bonds.
In addition to that, the amount that is deductible in a given year is capped at the net taxable investment income for that year.
If there is any remaining interest expense, it will be carried forward to the next year. You can use it potentially to reduce taxes in the year to follow.
Calculating deductible investment
You must know a few basic facts to calculate the deductible interest expenses on your investments:
- The total investment income for the investments that are taxed as per your ordinary income rate
- The total amount of investment interest expenses on the loans that you have used to purchase taxable investments.
The process to follow to calculate the deductible investment interest expense involves determining the net investment income. This includes the ordinary interest income and dividends but will not include that investment income that is taxed at a lower capital gains tax rates such as municipal bond interest, qualified dividends and others that are usually not taxed.
Next, you must compare the net investment income to the investment interest expenses. If it is less than the net investment income, you can claim for deduction of the entire investment interest expense. On the other hand, if it is more, then you can you can deduct up to the net investment income amount. The remaining amount will be carried forward to next year.