Investment Expenses

You can generally deduct the expenses of producing taxable investment income. These include expenses for investment counseling and advice, legal and accounting fees, and investment newsletters. These expenses are deductible as miscellaneous itemized deductions to the extent that they exceed 2% of your adjusted gross income. See chapter 3 in Publication 550 for more information.

Interest paid on money to buy or carry investment property is also deductible, but the deduction may be limited. See Limit on Investment Interest Expense, later.

Publicly offered mutual funds. Most mutual funds are publicly offered. Expenses of publicly offered mutual funds are not treated as miscellaneous itemized deductions. This is because these mutual funds report only the net amount of investment income after your share of the investment expenses has been deducted.

Nonpublicly offered mutual funds. If you own shares in a nonpublicly offered mutual fund during the year, you can deduct your share of the investment expenses on your Schedule A (Form 1040). Claim them as a miscellaneous itemized deduction to the extent your miscellaneous itemized deductions exceed 2% of your adjusted gross income. Your share of the expenses will be shown in box 5 of Form 1099-DIV. A nonpublicly offered mutual fund is one that:

1. Is not continuously offered pursuant to a public offering,
2. Is not regularly traded on an established securities market, and
3. Is held by fewer than 500 persons at any time during the tax year.

Contact your mutual fund if you are not sure whether it is nonpublicly offered.

Expenses allocable to exempt-interest dividends. You cannot deduct expenses that are for the collection or production of exempt-interest dividends. Expenses must be allocated if they were for both taxable and tax-exempt income. One accepted method for allocating expenses is to divide them in the same proportion that each type of income from the mutual fund is to your total income from the fund. To find the part of the expenses that relates to the tax-exempt income, you must first divide your tax-exempt income by your total income. Then multiply your expenses by the result. You cannot deduct this part.

Example. William received $600 in dividends from his mutual fund: exempt-interest dividends of $480 and taxable dividends of $120. In earning this income, he had a $50 expense for a newsletter on mutual funds. William divides the exempt-interest dividends by the total dividends to figure the part of the expense that is not deductible. Therefore, 80% ($480 x $600) of William's expense is for exempt-interest income. He cannot deduct $40 (80% of $50) of the expense. William may claim the balance of the expense, $10, as a miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income limit. That is the part of the expense allocable to the taxable dividends.

Limit on Investment Interest Expense

The amount you can deduct as investment interest expense may be limited in two different ways. First, you may not deduct the interest on money you borrow to buy or carry shares in a mutual fund that distributes only exempt-interest dividends. If the fund also distributes taxable dividends, you must allocate the interest between the taxable and nontaxable income. Allocate the interest as explained under Expenses allocable to exempt-interest dividends, earlier.

Second, your deduction for investment interest expense is limited to the amount of your net investment income.

Net investment income. This is figured by subtracting your investment expenses other than interest from your investment income. For this purpose, do not include any income or expenses taken into account to figure gain or loss from passive activities.

Investment income. Investment income generally includes gross income derived from property held for investment (such as interest, dividends, annuities, and royalties). It generally does not include net capital gain derived from disposing of investment property or capital gain distributions from mutual fund shares. However, you can choose to include part or all of your net capital gain in investment income. For information on this choice, see chapter 3 of Publication 550.

Investment expenses. Investment expenses include all income-producing expenses relating to the investment property, other than interest expenses, that are allowable deductions after subtracting 2% of adjusted gross income. In computing the amount over the 2% limit, miscellaneous expenses that are not investment expenses are disallowed before any investment expenses are disallowed.

For information on the 2% limit, get Publication 529, Miscellaneous Deductions. For more information on passive activity losses, get Publication 925, Passive Activity and At-Risk Rules.

Example. Jane, a single taxpayer, has investment income for the year of $12,000. Jane's investment expenses (other than interest expense) directly connected with the production of income were $980 after subtracting the 2% limit on miscellaneous itemized deductions. Jane incurred $12,500 of investment interest expense during the year. She had no passive activity losses. Jane figures net investment income and the limit on her investment interest expense deduction as follows:

For the year, Jane's investment interest expense deduction is limited to $11,020 (her net investment income). The disallowed interest expense of $1,480 ($12,500 - $11,020) can be carried forward to the following year as explained next under Carryover.

Carryover. You can carry forward to the next tax year the investment interest that you cannot deduct because of the limit. You can deduct the interest carried forward to the extent that your net investment income exceeds your investment interest in that later year.

Form 4952. Use Form 4952 to figure your investment interest expense deduction. For more information about investment interest expense, get Publication 550.

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