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deductible interest expense allocable
Investment interest is deductible as an to the tax year’s accrued market
discount may be disallowed for the
itemized deduction but limited to net tax year. The disallowed amount (if
investment income. any) is then deductible as interest ex-
pense in one or more later years (Sec.
1277(b)(2)).

Electing to include qualified
dividend income and net
If funds from a home-equity loan considered only to the extent a deduc- capital gains in investment
are used to purchase taxable investment tion is allowed. income
securities, and the taxpayer has sufficient Observation: With the disallowance The definition of net investment income
investment income to deduct the inter- of investment expenses under Sec. 212 excludes qualified dividend income and
est as investment interest, the taxpayer from 2018–2025 (as part of the general net capital gains (i.e., the excess of net
should consider using the tracing rules disallowance of miscellaneous itemized long-term capital gains over net short-
of Temp. Regs. Sec. 1.163-8T to classify deductions subject to the 2%-of-AGI term capital losses) unless the taxpayer
the interest as investment interest since floor under Sec. 67(g)), investment in- elects to include all or part of these
the deduction for home-equity inter- come will have few, if any, offsets in the in investment income (Sec. 163(d)(4)
est is suspended from 2018–2025 (Sec. calculation of net investment income in (B)). The election for gains is available
163(h)(3)(F)(i)). these years. only for net capital gains resulting from
Caution: No guidance has yet been For item (2) above, only dispositions the disposition of property held for
issued on using the tracing rules of of property held for investment are investment. (Sec. 1231 gains treated as
Temp. Regs. Sec. 1.163-8T to reallocate considered (i.e., Sec. 1231 gains treated long-term capital gains are not available
home-equity interest that has been as long-term capital gains are not con- for the election.)
disallowed by Sec. 163(h)(3)(F)(i). sidered), and net gain refers to the net If the election is made, the amount
Practitioners should be alert for future gain from all investment assets whether of qualified dividend income and net
developments. short-term or long-term. Capital loss capital gain included in net investment
Investment interest is deductible as carryovers must be considered when income is no longer eligible for the fa-
an itemized deduction but limited to computing net gain (IRS Letter Rul- vorable capital gains rates. In effect, this
net investment income. Net investment ing 9549002). Net capital gain refers to causes the elected amount to be treated
income is defined as the excess of invest- the excess of net long-term capital gain as ordinary income and potentially taxed
ment income over investment expenses over net short-term capital loss. The at rates as high as 40.8% (37% + 3.8%
(Sec. 163(d)(4)(A)). Investment income intent is to exclude net capital gains (i.e., net investment income tax). The elec-
includes (1) gross income from property gains taxed at favorable capital gains tion is made on or before the due date
held for investment (e.g., interest), (2) rates) from investment income unless (including extensions) of the income tax
the excess of any net gain over any net the taxpayer elects to include all or part return for the tax year in which the net
capital gain resulting from the disposi- of these. capital gain is recognized or the quali-
tion of investment property, and (3) as Sec. 1277 contains a little-known fied dividend income is received (Regs.
much of the taxpayer’s qualified divi- rule that can cause a deferral of part Sec. 1.163(d)-1(b)).
dend income and net capital gain from of the interest expense traced to The election to include net capital gain
the disposition of investment property debt-financed investments in taxable is limited to the lesser of (1) net capital
as he or she elects to include (see the market discount bonds (MDBs). It gains from property held for investment
following discussion of the election). applies to MDBs acquired after July or (2) net gains from property held for in-
Investment expenses are the deduc- 18, 1984. (The rule does not apply vestment. For example, an investor with a
tions allowed (other than interest) that to debt-financed tax-free MDBs net capital gain of $5,000 and a Sec. 1244
are directly related to the production because the interest to carry tax-free ordinary loss of $3,000 has a net gain of
of investment income (Sec. 163(d)(4) investments is not deductible anyway $2,000. Thus, the amount eligible for the
(C)). An expense subject to the 2%-of- (see Secs. 265(a)(2) and 1278(a)(1) election is limited to $2,000.
adjusted-gross-income (AGI) limitation (C)).) The effect of the rule is that When the election is made and the
on miscellaneous itemized deductions is the portion of a taxpayer’s otherwise taxpayer has net capital gains in the

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