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CASE STUDY
CASE STUDY
Maximizing the investment
interest deduction
Editor: Investment interest is interest paid or interest, the net income or loss will im-
Patrick L. Young, CPA accrued on indebtedness incurred to pact investment income. Thus, taxpayers
purchase or carry property held for who do not materially participate in a
investment (Sec. 163(d)(3)(A)). Invest- working interest that generates a net loss
ment interest does not include qualified must reduce their net investment income
residence interest or interest incurred by the net loss. These taxpayers may
in a passive activity (Sec. 163(d)(3)(B)). benefit by taking steps that would allow
However, if a passive activity generates them to meet the material participation
portfolio income (interest, dividends, standard for the activity so the net loss
etc.), the portion of the passive activity does not reduce their allowable invest-
interest expense allocable to the portfo- ment interest expense.
In deciding whether lio income is investment interest rather Investment interest expense does not
to elect to defer than passive activity interest (Notice include interest expense that is capital-
ized (e.g., under Sec. 263A) or interest
89-35; IRS Letter Ruling 9037027).
investment interest Property held for investment in- expense related to tax-exempt income
expense, a taxpayer cludes any property producing interest, that is not deductible under Sec. 265(a)
dividends, annuities, royalties, and
(2). This rule also applies to mutual
needs to consider gain-generating property other than funds so that if a fund invests in both
marginal tax brackets that used in a trade or business activity taxable and tax-exempt securities, the
and the time value or passive activity. Investment property interest expense must be allocated pro-
also includes an interest involving the
portionately based on the income from
of money. conduct of a trade or business that is the fund. Prepaid interest on a margin
not considered a passive activity but in account is generally not deductible in
which the taxpayer does not materi- the year paid (unlike other itemized
ally participate (generally, oil and gas deductions, such as state income or
working interests in which the taxpayer real estate taxes); instead, it is carried
does not materially participate) (Sec. forward and deducted in the year when
163(d)(5)). Income from these proper- it properly accrues (Sec. 461(g); Rev.
ties increases investment income, while Rul. 68-643, as modified by Rev. Rul.
deductions (including net losses from 69-582).
oil and gas working interests treated as Interest expense incurred by a
investment property) related to them trader who materially participates in
reduce investment income. the trading activity is not subject to the PHOTO BY COMSTOCK/STOCKBYTE/THINKSTOCK
This case study has been adapted Taxpayers with oil and gas working investment interest expense limitations
from Checkpoint Tax Planning and interests must consider these rules if (King, 89 T.C. 445 (1987)). Whether a
Advisory Guide’s Individual Tax Planning
topic. Published by Thomson Reuters, they are subject to investment interest taxpayer is a trader or investor generally
Carrollton, Texas, 2022 (800-431-9025; expense limitations. If the taxpayer does depends on the amount of trading activ-
tax.thomsonreuters.com). not materially participate in the working ity and other factors.
52 March 2022 The Tax Adviser
