Page 163 - TaxAdviser_2022

CASE STUDY

+ 3.8% net investment income tax)
Interest expense incurred by a trader who capital gain rate, the cost of making
the election increases. If the election is
materially participates in the trading activity made, J must pay additional tax of $396
is not subject to the investment interest ($3,000 × [32% − 18.8%]) on the capi-
tal gain. Thus, making the election to
expense limitations. claim the deduction in 20X1 results in
net tax savings of only $564, an 18.8%
tax benefit ([$3,000 × 32%] − $396). By
not making the election and carrying
the deduction forward, J may be able to
increase his tax savings from the deduc-
15%, 20%, and 28% rate categories, $2,000 of interest income and tion to $960, a 32% tax benefit in 20X2.
those subject to the 15% and 20% rates $6,500 of net long-term capital gain. Thus, forgoing the election may be the
are treated as ordinary income before He also has $5,000 of investment preferred strategy in this case.
those subject to the 28% rate (Sec. 1(h) interest expense from broker margin Similarly, if J expected his 20X2
(4)). accounts. He expects his 20X2 in- investment income to increase so that
Obviously, an election should not be come and deductions to be similar to the investment interest carryover would
made if a taxpayer has sufficient other 20X1. Without an election, J can de- be deductible in 20X2 and he expected
current-year net investment income duct $2,000 of his 20X1 investment his 20X2 taxable income to increase
to allow a deduction of all investment interest expense and carry forward significantly so that he would be in a
interest expense. Because disallowed the remaining $3,000 indefinitely. higher tax bracket, a decision to forgo
investment interest expense carries over the election and defer the deduction to
indefinitely, deciding whether to make The decision on whether to make 20X2 is probably the better choice.
the election may require an analysis the election may depend on the ap-
that includes a number of future tax plicable capital gain rate. If the election Example 2. Present-value analysis
years. Key factors in making the deci- causes gain subject to the 31.8% (28% aids in election decision: In 20X1, L
sion are (1) current and future (antici- + 3.8% net investment income tax) rate paid $30,000 in investment interest
pated) marginal tax rates, (2) expected (e.g., collectibles gain) to be treated expense and has interest income
net investment income (excluding net as ordinary income, no significant of $10,000 and net capital gains of
capital gains and qualified dividends) tax benefit is received by carrying the $20,000, all subject to a 23.8% (20%
and investment interest expense for deduction over to 20X2. (The best he + 3.8% net investment income tax)
future tax years, and (3) the taxpayer’s could do is receive a 32% tax benefit, capital gains rate. He files single and
discount rate or factor for computing assuming the interest is deductible in is in a 45% (including 3.8% net in-
his or her time value of money. With 20X2, rather than the net 31.8% tax vestment income tax) combined fed-
this information, a reasonable present- benefit he could receive by electing eral and state tax bracket. In 20X2,
value analysis can be done to determine to include a portion of the long-term he will pay off his investment debt
whether the election is beneficial. gain in investment income in 20X1.) so he will have little or no invest-
Of course, the amount of disallowed Thus, it is probably better for J to ment interest expense that year, and
investment interest expense would de- make the election in 20X1 and treat he expects his interest income that
termine whether an extensive analysis is $3,000 of the net capital gain as invest- year to total $20,000. He expects to
necessary and cost-effective. ment income. The $6 ($3,000 × [32% be in a 40% combined tax bracket in
− 31.8%]) of additional tax paid on 20X2. He uses a 6% discount rate in
Example 1. Electing to include net the net capital gain is offset by a $960 analyzing his investments.
capital gains in investment income: ($3,000 × 32%) tax savings from the
For 20X1, J has $250,000 of taxable additional interest expense deduction. Here, a present-value analysis
income, files as single, and is in the Thus, the actual 20X1 tax benefit real- makes sense because of the amount of
32% tax bracket. He is subject to ized from the additional deduction is investment interest involved and the
the 3.8% net investment income 31.8%, or $954. taxpayer’s changing tax rates for the af-
tax since his taxable income exceeds However, if the election affects a fected years. The analysis helps quantify
$200,000. J’s income includes $3,000 gain subject to the 18.8% (15% the effects of making the election to

54 March 2022 The Tax Adviser