Publication 550: Investment Income and Expenses; Chapter 3

This is archived information that pertains only to the 2004 Tax Year. If you
are looking for information for the current tax year, go to the Tax Prep Help Area.

Terms you may need to know (see Glossary):

At-risk rules

Passive activity

Portfolio income

Topics - This chapter discusses:

Limits on deductions,
Interest expenses,
Bond premium amortization,
Expenses of producing income,
Nondeductible expenses, and
How to report investment expenses.

Useful Items - You may want to see:

Publication

535 Business Expenses
925 Passive Activity and At-Risk Rules
929 Tax Rules for Children and Dependents

Form (and Instructions)

Schedule A (Form 1040)
Itemized Deductions
4952
Investment Interest Expense Deduction

See chapter 5 for information about getting these publications and forms.

Limits on Deductions

Your deductions for investment expenses may be limited by:

The at-risk rules,
The passive activity loss limits,
The limit on investment interest, or
The 2% limit on certain miscellaneous itemized deductions.

The at-risk rules and passive activity rules are explained briefly in this section. The limit on investment interest is explained later in this chapter under Interest Expenses. The 2% limit is explained later in this chapter under Expenses of Producing Income.

At-risk rules. Special at-risk rules apply to most income-producing activities. These rules limit the amount of loss you can deduct to the amount you risk losing in the activity. Generally, this is the amount of cash and the adjusted basis of property you contribute to the activity. It also includes money you borrow for use in the activity if you are personally liable for repayment or if you use property not used in the activity as security for the loan. For more information, see Publication 925.

Passive activity losses and credits. The amount of losses and tax credits you can claim from passive activities is limited. Generally, you are allowed to deduct passive activity losses only up to the amount of your passive activity income. Also, you can use credits from passive activities only against tax on the income from passive activities. There are exceptions for certain activities, such as rental real estate activities.

Passive activity. A passive activity generally is any activity involving the conduct of any trade or business in which you do not materially participate and any rental activity. However, if you are involved in renting real estate, the activity is not a passive activity if both of the following are true.

More than one-half of the personal services you perform during the year in all trades or businesses are performed in real property trades or businesses in which you materially participate.
You perform more than 750 hours of services during the year in real property trades or businesses in which you materially participate.

The term “trade or business” generally means any activity that involves the conduct of a trade or business, is conducted in anticipation of starting a trade or business, or involves certain research or experimental expenditures. However, it does not include rental activities or certain activities treated as incidental to holding property for investment.

You are considered to materially participate in an activity if you are involved on a regular, continuous, and substantial basis in the operations of the activity.

Other income (nonpassive income). Generally, you can use losses from passive activities only to offset income from passive activities. You generally cannot use passive activity losses to offset your other income, such as your wages or your portfolio income. Portfolio income includes gross income from interest, dividends, annuities, or royalties that is not derived in the ordinary course of a trade or business. It also includes gains or losses (not derived in the ordinary course of a trade or business) from the sale or trade of property (other than an interest in a passive activity) producing portfolio income or held for investment. This includes capital gain distributions from mutual funds and real estate investment trusts.

You cannot use passive activity losses to offset Alaska Permanent Fund dividends.

Expenses. Do not include in the computation of your passive activity income or loss:

Expenses (other than interest) that are clearly and directly allocable to your portfolio income, or
Interest expense properly allocable to portfolio income.

However, this interest and other expenses may be subject to other limits. These limits are explained in the rest of this chapter.

Additional information. For more information about determining and reporting income and losses from passive activities, see Publication 925.

Interest Expenses

This section discusses interest expenses you may be able to deduct as an investor.

For information on business interest, see chapter 5 of Publication 535.

You cannot deduct personal interest expenses other than qualified home mortgage interest, as explained in Publication 936, Home Mortgage Interest Deduction, and interest on certain student loans, as explained in Publication 970, Tax Benefits for Education.

Investment Interest

If you borrow money to buy property you hold for investment, the interest you pay is investment interest. You can deduct investment interest subject to the limit discussed later. However, you cannot deduct interest you incurred to produce tax-exempt income. See Tax-exempt income under Nondeductible Expenses, later. Nor can you deduct interest expenses on straddles, also discussed under Nondeductible Expenses.

Investment interest does not include any qualified home mortgage interest or any interest taken into account in computing income or loss from a passive activity.

Investment property. Property held for investment includes property that produces interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. It also includes property that produces gain or loss (not derived in the ordinary course of a trade or business) from the sale or trade of property producing these types of income or held for investment (other than an interest in a passive activity). Investment property also includes an interest in a trade or business activity in which you did not materially participate (other than a passive activity).

Partners, shareholders, and beneficiaries. To determine your investment interest, combine your share of investment interest from a partnership, S corporation, estate, or trust with your other investment interest.

Allocation of Interest Expense

If you borrow money for business or personal purposes as well as for investment, you must allocate the debt among those purposes. Only the interest expense on the part of the debt used for investment purposes is treated as investment interest. The allocation is not affected by the use of property that secures the debt.

Example 1.

You borrow $10,000 and use $8,000 to buy stock. You use the other $2,000 to buy items for your home. Since 80% of the debt is used for, and allocated to, investment purposes, 80% of the interest on that debt is investment interest. The other 20% is nondeductible personal interest.

Debt proceeds received in cash. If you receive debt proceeds in cash, the proceeds are generally not treated as investment property.

Debt proceeds deposited in account. If you deposit debt proceeds in an account, that deposit is treated as investment property, regardless of whether the account bears interest. But, if you withdraw the funds and use them for another purpose, you must reallocate the debt to determine the amount considered to be for investment purposes.

Example 2.

Assume in Example 1 that you borrowed the money on March 1 and immediately bought the stock for $8,000. You did not buy the household items until June 1. You had deposited the $2,000 in the bank. You had no other transactions on the bank account until June. You did not sell the stock and you made no principal payments on the debt. You paid interest from another account. The $8,000 is treated as being used for an investment purpose. The $2,000 is treated as being used for an investment purpose for the 3-month period. Your total interest expense for 3 months on this debt is investment interest. In June, when you spend the $2,000 for household items, you must begin to allocate 80% of the debt and the interest expense to investment purposes and 20% to personal purposes.

Amounts paid within 30 days. If you receive loan proceeds in cash or if the loan proceeds are deposited in an account, you can treat any payment (up to the amount of the proceeds) made from any account you own, or from cash, as made from those proceeds. This applies to any payment made within 30 days before or after the proceeds are received in cash or deposited in your account.

If you received the loan proceeds in cash, you can treat the payment as made on the date you received the cash instead of the date you actually made the payment.

Payments on debt may require new allocation. As you repay a debt used for more than one purpose, you must reallocate the balance. You must first reduce the amount allocated to personal purposes by the repayment. You then reallocate the rest of the debt to find what part is for investment purposes.

Example 3.

If, in Example 2, you repay $500 on November 1, the entire repayment is applied against the amount allocated to personal purposes. The debt balance is now allocated as $8,000 for investment purposes, and $1,500 for personal purposes. Until the next reallocation is necessary, 84% ($8,000 ÷ $9,500) of the debt and the interest expense is allocated to investment.

Pass-through entities. If you use borrowed funds to buy an interest in a partnership or S corporation, then the interest on those funds must be allocated based on the assets of the entity. If you contribute to the capital of the entity, you can make the allocation using any reasonable method.

Additional allocation rules. For more information about allocating interest expense, see chapter 5 of Publication 535.

When To Deduct Investment Interest

If you use the cash method of accounting, you must pay the interest before you can deduct it.

If you use an accrual method of accounting, you can deduct interest over the period it accrues, regardless of when you pay it. For an exception, see Unpaid expenses owed to related party under When To Report Investment Expenses, later in this chapter.

Example.

You borrowed $1,000 on September 3, 2004, payable in 90 days at 12% interest. On December 2, 2004, you paid this with a new note for $1,030, due on March 2, 2005. If you use the cash method of accounting, you cannot deduct any part of the $30 interest on your return for 2004 because you did not actually pay it. If you use an accrual method, you may be able to deduct a portion of the interest on the loans through December 31, 2004, on your return for 2004.

Interest paid in advance. Generally, if you pay interest in advance for a period that goes beyond the end of the tax year, you must spread the interest over the tax years to which it belongs under the OID rules discussed in chapter 1. You can deduct in each year only the interest for that year.

Interest on margin accounts. If you are a cash method taxpayer, you can deduct interest on margin accounts to buy taxable securities as investment interest in the year you paid it. You are considered to have paid interest on these accounts only when you actually pay the broker or when payment becomes available to the broker through your account. Payment may become available to the broker through your account when the broker collects dividends or interest for your account, or sells securities held for you or received from you.

You cannot deduct any interest on money borrowed for personal reasons.

Limit on interest deduction for market discount bonds. The amount you can deduct for interest expense you paid or accrued during the year to buy or carry a market discount bond may be limited. This limit does not apply if you accrue the market discount and include it in your income currently.

Under this limit, the interest is deductible only to the extent it is more than:

The total interest and OID includible in gross income for the bond for the year, plus
The market discount for the number of days you held the bond during the year.

Figure the amount in (2) above using the rules for figuring accrued market discount in chapter 1 under Market Discount Bonds.

Interest not deducted due to limit. In the year you dispose of the bond, you can deduct the amount of any interest expense you were not allowed to deduct in earlier years because of the limit.

Choosing to deduct disallowed interest expense before the year of disposition. You can choose to deduct disallowed interest expense in any year before the year you dispose of the bond, up to your net interest income from the bond during the year. The rest of the disallowed interest expense remains deductible in the year you dispose of the bond.

Net interest income. This is the interest income (including OID) from the bond that you include in income for the year, minus the interest expense paid or accrued during the year to purchase or carry the bond.

Limit on interest deduction for short-term obligations. If the current income inclusion rules discussed in chapter 1 under Discount on Short-Term Obligations do not apply to you, the amount you can deduct for interest expense you paid or accrued during the year to buy or carry a short-term obligation is limited.

The interest is deductible only to the extent it is more than:

The amount of acquisition discount or OID on the obligation for the tax year, plus
The amount of any interest payable on the obligation for the year that is not included in income because of your accounting method (other than interest taken into account in determining the amount of acquisition discount or OID).

The method of determining acquisition discount and OID for short-term obligations is discussed in chapter 1 under Discount on Short-Term Obligations.

Interest not deducted due to limit. In the year you dispose of the obligation, or if you choose, in another year in which you have net interest income from the obligation, you can deduct the amount of any interest expense you were not allowed to deduct for an earlier year because of the limit. Follow the same rules provided in the earlier discussion under Limit on interest deduction for market discount bonds, earlier.

Limit on Deduction

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

You can carry over the amount of investment interest that you could not deduct because of this limit to the next tax year. The interest carried over is treated as investment interest paid or accrued in that next year.

You can carry over disallowed investment interest to the next tax year even if it is more than your taxable income in the year the interest was paid or accrued.

Net Investment Income

Determine the amount of your net investment income by subtracting your investment expenses (other than interest expense) from your investment income.

Investment income. This generally includes your gross income from property held for investment (such as interest, dividends, annuities, and royalties). Investment income does not include Alaska Permanent Fund dividends. It also does not include qualified dividends or net capital gain unless you choose to include them.

Choosing to include qualified dividends. Investment income generally does not include qualified dividends, discussed in chapter 1. However, you can choose to include all or part of your qualified dividends in investment income.

You make this choice by completing Form 4952, line 4g, according to its instructions.

If you choose to include any amount of your qualified dividends in investment income, you must reduce your qualified dividends that are eligible for the lower capital gains tax rates by the same amount.

Choosing to include net capital gain. Investment income generally does not include net capital gain from disposing of investment property (including capital gain distributions from mutual funds). However, you can choose to include all or part of your net capital gain in investment income.

You make this choice by completing Form 4952, line 4g, according to its instructions.

If you choose to include any amount of your net capital gain in investment income, you must reduce your net capital gain that is eligible for the lower capital gains tax rates by the same amount.

For more information about the capital gains rates, see Capital Gain Tax Rates in chapter 4.

Before making either choice, consider the overall effect on your tax liability. Compare your tax if you make one or both of these choices with your tax if you do not.

Investment income of child reported on parent's return. Investment income includes the part of your child's interest and dividend income that you choose to report on your return. If the child does not have qualified dividends, Alaska Permanent Fund dividends, or capital gain distributions, this is the amount on line 6 of Form 8814, Parents' Election To Report Child's Interest and Dividends. Include it on line 4a of Form 4952.

Example.

Your 8-year-old son has interest income of $2,000, which you choose to report on your own return. You enter $2,000 on Form 8814, lines 1a and 4, and $400 on line 6. Also enter $400 on Form 1040, line 21. Your investment income includes this $400.

Child's qualified dividends. If part of the amount you report is your child's qualified dividends, that part (which is reported on Form 1040, line 9b) generally does not count as investment income. However, you can choose to include all or part of it in investment income, as explained under Choosing to include qualified dividends, earlier.

Your investment income also includes the amount on Form 8814, line 6 (or, if applicable, the reduced amount figured next under Child's Alaska Permanent Fund dividends).

Child's Alaska Permanent Fund dividends. If part of the amount you report is your child's Alaska Permanent Fund dividends, that part does not count as investment income. To figure the amount of your child's income that you can consider your investment income, start with the amount on Form 8814, line 6. Multiply that amount by a percentage that is equal to the Alaska Permanent Fund dividends divided by the total amount of interest and dividend income on Form 8814, lines 1a and 2. Subtract the result from the amount on Form 8814, line 6.

Example.

Your 10-year-old child has taxable interest income of $4,000 and Alaska Permanent Fund dividends of $2,000. You choose to report this on your return. You enter $4,000 on Form 8814, line 1a, $2,000 on line 2, and $6,000 on line 4. You then enter $4,400 on Form 8814, line 6, and Form 1040, line 21. You figure the amount of your child's income that you can consider your investment income as follows:

$4,400 - ($4,400 × ($2,000 ÷ $6,000))

You include this $2,933 on Form 4952, line 4a.

Child's capital gain distributions. If part of the amount you report is your child's capital gain distributions, that part (which is reported on Schedule D, line 13, or Form 1040, line 13) generally, does not count as investment income. However, you can choose to include all or part of it in investment income, as explained in Choosing to include net capital gain, earlier.

Your investment income also includes the amount on Form 8814, line 6 (or, if applicable, the reduced amount figured under Child's Alaska Permanent Fund dividends, earlier).

Investment expenses. Investment expenses include all income-producing expenses (other than interest expense) relating to investment property that are allowable deductions after applying the 2% limit that applies to miscellaneous itemized deductions. Use the smaller of:

The investment expenses included on Schedule A (Form 1040), line 22, or
The amount on Schedule A, line 26.

See Expenses of Producing Income, later, for a discussion of the 2% limit.

Losses from passive activities. Income or expenses that you used in computing income or loss from a passive activity are not included in determining your investment income or investment expenses (including investment interest expense). See Publication 925 for information about passive activities.

Example.

Ted is a partner in a partnership that operates a business. However, he does not materially participate in the partnership's business. Ted's interest in the partnership is considered a passive activity.

Ted's investment income from interest and dividends (other than qualified dividends) is $10,000. His investment expenses (other than interest) are $3,200 after taking into account the 2% limit on miscellaneous itemized deductions. His investment interest expense is $8,000. Ted also has income from the partnership of $2,000.

Ted figures his net investment income and the limit on his investment interest expense deduction in the following way:

Total investment income	$10,000
Minus: Investment expenses (other than interest)	3,200
Net investment income	$6,800
Deductible investment interest expense for the year	$6,800

The $2,000 of income from the passive activity is not used in determining Ted's net investment income. His investment interest deduction for the year is limited to $6,800, the amount of his net investment income.

Form 4952

Use Form 4952, Investment Interest Expense Deduction, to figure your deduction for investment interest.

Example.

Jane Smith is single. Her 2004 income includes $3,000 in dividends (other than qualified dividends) and a net capital gain of $9,000 from the sale of investment property. She incurred $12,500 of investment interest expense. Her other investment expenses directly connected with the production of investment income total $980 after applying the 2% limit on miscellaneous itemized deductions on Schedule A (Form 1040).

For 2004, Jane chooses to include all of her net capital gain in investment income. Her total investment income is $12,000 ($3,000 dividends + $9,000 net capital gain). Her net investment income is $11,020 ($12,000 total investment income - $980 other investment expenses).

Jane's Form 4952 is illustrated, later. Her investment interest expense deduction is limited to $11,020, the amount of her net investment income. The $1,480 disallowed investment interest expense is carried forward to 2005.

Exception to use of Form 4952. You do not have to complete Form 4952 or attach it to your return if you meet all of the following tests.

Your investment interest expense is not more than your investment income from interest and ordinary dividends minus any qualified dividends.
You do not have any other deductible investment expenses.
You have no carryover of investment interest expense from 2003.

If you meet all of these tests, you can deduct all of your investment interest.

Illustrated Form 4952

Bond Premium Amortization

If you pay a premium to buy a bond, the premium is part of your basis in the bond. If the bond yields taxable interest, you can choose to amortize the premium. This generally means that each year, over the life of the bond, you use a part of the premium to reduce the amount of interest includible in your income. If you make this choice, you must reduce your basis in the bond by the amortization for the year.

If the bond yields tax-exempt interest, you must amortize the premium. This amortized amount is not deductible in determining taxable income. However, each year you must reduce your basis in the bond (and tax-exempt interest otherwise reportable on Form 1040, line 8b) by the amortization for the year.

Bond premium. Bond premium is the amount by which your basis in the bond right after you get it is more than the total of all amounts payable on the bond after you get it (other than payments of qualified stated interest). For example, a bond with a maturity value of $1,000 generally would have a $50 premium if you buy it for $1050.

Basis. In general, your basis for figuring bond premium amortization is the same as your basis for figuring any loss on the sale of the bond. However, you may need to use a different basis for:

Convertible bonds,
Bonds you got in a trade, and
Bonds whose basis has to be determined using the basis of the person who transferred the bond to you.

See Regulations section 1.171-1(e).

Dealers. A dealer in taxable bonds (or anyone who holds them mainly for sale to customers in the ordinary course of a trade or business or who would properly include bonds in inventory at the close of the tax year) cannot claim a deduction for amortizable bond premium.

See section 75 of the Internal Revenue Code for the treatment of bond premium by a dealer in tax-exempt bonds.

How To Figure Amortization

For bonds issued after September 27, 1985, you must amortize bond premium using a constant yield method on the basis of the bond's yield to maturity, determined by using the bond's basis and compounding at the close of each accrual period.

Constant yield method. Figure the bond premium amortization for each accrual period as follows.

Step 1: determine your yield. Your yield is the discount rate that, when used in figuring the present value of all remaining payments to be made on the bond (including payments of qualified stated interest), produces an amount equal to your basis in the bond. Figure the yield as of the date you got the bond. It must be constant over the term of the bond and must be figured to at least two decimal places when expressed as a percentage.

If you do not know the yield, consult your broker or tax advisor. Databases available to them are likely to show the yield at the date of purchase.

Step 2: determine the accrual periods. You can choose the accrual periods to use. They may be of any length and may vary in length over the term of the bond, but each accrual period can be no longer than 1 year and each scheduled payment of principal or interest must occur either on the first or the final day of an accrual period. The computation is simplest if accrual periods are the same as the intervals between interest payment dates.

Step 3: determine the bond premium for the accrual period. To do this, multiply your adjusted acquisition price at the beginning of the accrual period by your yield. Then subtract the result from the qualified stated interest for the period.

Your adjusted acquisition price at the beginning of the first accrual period is the same as your basis. After that, it is your basis decreased by the amount of bond premium amortized for earlier periods and the amount of any payment previously made on the bond other than a payment of qualified stated interest.

Example.

On February 3, 2003, you bought a taxable bond for $110,000. The bond has a stated principal amount of $100,000, payable at maturity on February 3, 2010, making your premium $10,000 ($110,000 - $100,000). The bond pays qualified stated interest of $10,000 on February 3 of each year. Your yield is 8.07439% compounded annually. You choose to use annual accrual periods ending on February 3 of each year. To find your bond premium amortization for the accrual period ending on February 3, 2004, you multiply the adjusted acquisition price at the beginning of the period ($110,000) by your yield. When you subtract the result ($8,881.83) from the qualified stated interest for the period ($10,000), you find that your bond premium amortization for the period is $1,118.17.

Special rules. For special rules that apply to variable rate bonds, inflation-indexed bonds, and bonds that provide for alternative payment schedules or remote or incidental contingencies, see Regulations section 1.171-3.

Bonds Issued Before September 28, 1985

For these bonds, you can amortize bond premium using any reasonable method. Reasonable methods include:

The straight-line method, and
The Revenue Ruling 82-10 method.

Straight-line method. Under this method, the amount of your bond premium amortization is the same each month. Divide the number of months you held the bond during the year by the number of months from the beginning of the tax year (or, if later, the date of acquisition) to the date of maturity or earlier call date. Then multiply the result by the bond premium (reduced by any bond premium amortization claimed in earlier years). This gives you your bond premium amortization for the year.

Revenue Ruling 82-10 method. Under this method, the amount of your bond premium amortization increases each month over the life of the bond. This method is explained in Revenue Ruling 82-10.

Choosing To Amortize

You choose to amortize the premium on taxable bonds by reporting the amortization for the year on your income tax return for the first tax year for which you want the choice to apply. You should attach a statement to your return that you are making this choice under section 171. See How To Report Amortization, next.

This choice is binding for the year you make it and for later tax years. It applies to all taxable bonds you own in the year you make the choice and also to those you acquire in later years.

You can change your decision to amortize bond premium only with the written approval of the IRS. To request approval, use Form 3115, Application for Change in Accounting Method. For more information on requesting approval, see section 1C of the Appendix to Revenue Procedure 2002-9 in Internal Revenue Bulletin 2002-3. You can find this Internal Revenue Bulletin at www.irs.gov/pub/irs-irbs/irb02-03.pdf.

How To Report Amortization

Subtract the bond premium amortization from your interest income from these bonds.

Report the bond's interest on Schedule B (Form 1040), line 1. Several lines above line 2, put a subtotal of all interest listed on line 1. Below this subtotal, print “ABP Adjustment,” and the amortization amount. Subtract this amount from the subtotal, and enter the result on line 2.

Bond premium amortization more than interest. If the amount of your bond premium amortization for an accrual period is more than the qualified stated interest for the period, you can deduct the difference as a miscellaneous itemized deduction on Schedule A (Form 1040), line 27.

But your deduction is limited to the amount by which your total interest inclusions on the bond in prior accrual periods is more than your total bond premium deductions on the bond in prior periods. Any amount you cannot deduct because of this limit can be carried forward to the next accrual period.

Pre-1998 election to amortize bond premium. Generally, if you first elected to amortize bond premium before 1998, the above treatment of the premium does not apply to bonds you acquired before 1988.

Bonds acquired before October 23, 1986. The amortization of the premium on these bonds is a miscellaneous itemized deduction not subject to the 2%-of-adjusted-gross-income limit.

Bonds acquired after October 22, 1986, but before 1988. The amortization of the premium on these bonds is investment interest expense subject to the investment interest limit, unless you choose to treat it as an offset to interest income on the bond.

Expenses of Producing Income

You deduct investment expenses (other than interest expenses) as miscellaneous itemized deductions on Schedule A (Form 1040). To be deductible, these expenses must be ordinary and necessary expenses paid or incurred:

To produce or collect income, or
To manage property held for producing income.

The expenses must be directly related to the income or income-producing property, and the income must be taxable to you.

The deduction for most income-producing expenses is subject to a 2% limit that also applies to certain other miscellaneous itemized deductions. The amount deductible is limited to the total of these miscellaneous deductions that is more than 2% of your adjusted gross income.

For information on how to report expenses of producing income, see How To Report Investment Expenses, later.

Attorney or accounting fees. You can deduct attorney or accounting fees that are necessary to produce or collect taxable income. However, in some cases, attorney or accounting fees are part of the basis of property. See Basis of Investment Property in chapter 4.

Automatic investment service and dividend reinvestment plans. A bank may offer its checking account customers an automatic investment service so that, for a charge, each customer can choose to invest a part of the checking account each month in common stock. Or, a bank that is a dividend disbursing agent for a number of publicly-owned corporations may set up an automatic dividend reinvestment service. Through that service, cash dividends are reinvested in more shares of stock, after the bank deducts a service charge.

A corporation in which you own stock also may have a dividend reinvestment plan. This plan lets you choose to use your dividends to buy more shares of stock in the corporation instead of receiving the dividends in cash.

You can deduct the monthly service charge you pay to a bank to participate in an automatic investment service. If you participate in a dividend reinvestment plan, you can deduct any service charge subtracted from your cash dividends before the dividends are used to buy more shares of stock. Deduct the charges in the year you pay them.

Clerical help and office rent. You can deduct office expenses, such as rent and clerical help, that you pay in connection with your investments and collecting the taxable income on them.

Cost of replacing missing securities. To replace your taxable securities that are mislaid, lost, stolen, or destroyed, you may have to post an indemnity bond. You can deduct the premium you pay to buy the indemnity bond and the related incidental expenses.

You may, however, get a refund of part of the bond premium if the missing securities are recovered within a specified time. Under certain types of insurance policies, you can recover some of the expenses.

If you receive the refund in the tax year you pay the amounts, you can deduct only the difference between the expenses paid and the amount refunded. If the refund is made in a later tax year, you must include the refund in income in the year you received it, but only to the extent that the expenses decreased your tax in the year you deducted them.

Fees to collect income. You can deduct fees you pay to a broker, bank, trustee, or similar agent to collect investment income, such as your taxable bond or mortgage interest, or your dividends on shares of stock.

Fees to buy or sell. You cannot deduct a fee you pay to a broker to acquire investment property, such as stocks or bonds. You must add the fee to the cost of the property. See Basis of Investment Property in chapter 4.

You cannot deduct any broker's fees, commissions, or option premiums you pay (or that were netted out) in connection with the sale of investment property. They can be used only to figure gain or loss from the sale. See Reporting Capital Gains and Losses, in chapter 4, for more information about the treatment of these sale expenses.

Investment counsel and advice. You can deduct fees you pay for counsel and advice about investments that produce taxable income. This includes amounts you pay for investment advisory services.

Safe deposit box rent. You can deduct rent you pay for a safe deposit box if you use the box to store taxable income-producing stocks, bonds, or other investment-related papers and documents. If you also use the box to store tax-exempt securities or personal items, you can deduct only part of the rent. See Tax-exempt income under Nondeductible Expenses, later, to figure what part you can deduct.

State and local transfer taxes. You cannot deduct the state and local transfer taxes you pay when you buy or sell securities. If you pay these transfer taxes when you buy securities, you must treat them as part of the cost of the property. If you pay these transfer taxes when you sell securities, you must treat them as a reduction in the amount realized.

Trustee's commissions for revocable trust. If you set up a revocable trust and have its income distributed to you, you can deduct the commission you pay the trustee for managing the trust to the extent it is to produce or collect taxable income or to manage property. However, you cannot deduct any part of the commission that is for producing or collecting tax-exempt income or for managing property that produces tax-exempt income.

If you are a cash-basis taxpayer and pay the commissions for several years in advance, you must deduct a part of the commission each year. You cannot deduct the entire amount in the year you pay it.

Investment expenses from pass-through entities. If you hold an interest in a partnership, S corporation, real estate mortgage investment conduit (REMIC), or a nonpublicly offered regulated investment company (mutual fund), you can deduct your share of that entity's investment expenses. A partnership or S corporation will show your share of these expenses on your Schedule K-1. A nonpublicly offered mutual fund will indicate your share of these expenses in box 5 of Form 1099-DIV, or on an equivalent statement. Publicly-offered mutual funds are discussed later.

If you hold an interest in a REMIC, any expenses relating to your residual interest investment will be shown on Schedule Q (Form 1066), line 3b. Any expenses relating to your regular interest investment will appear in box 5 of Form 1099-INT or box 7 of Form 1099-OID.

Report your share of these investment expenses on Schedule A (Form 1040), subject to the 2% limit, in the same manner as your other investment expenses.

Including mutual fund or REMIC expenses in income. Your share of the investment expenses of a REMIC or a nonpublicly offered mutual fund, as described above, are considered to be indirect deductions through that pass-through entity. You must include in your gross income an amount equal to the amount of the expenses allocated to you, whether or not you are able to claim a deduction for those expenses. If you are a shareholder in a nonpublicly offered mutual fund, you must include on your return the full amount of ordinary dividends or other distributions of stock, as shown in box 1a of Form 1099-DIV or an equivalent statement. If you are a residual interest holder in a REMIC, you must report as ordinary income on Schedule E (Form 1040) the total amounts shown on Schedule Q (Form 1066), lines 1b and 3b. If you are a REMIC regular interest holder, you must include the amount of any expense allocation you received on Form 1040, line 8a.

Publicly-offered mutual funds. Publicly-offered mutual funds, generally, are funds that are traded on an established securities exchange. These funds do not pass investment expenses through to you. Instead, the dividend income they report to you in box 1a of Form 1099-DIV is already reduced by your share of investment expenses. Therefore, you cannot deduct the expenses on your return.

Include the amount from box 1a of Form 1099-DIV in your income.

Nondeductible Expenses

Some expenses that you incur as an investor are not deductible.

Stockholders' meetings. You cannot deduct transportation and other expenses that you pay to attend stockholders' meetings of companies in which you have no interest other than owning stock. This is true even if your purpose in attending is to get information that would be useful in making further investments.

Investment-related seminar. You cannot deduct expenses for attending a convention, seminar, or similar meeting for investment purposes.

Single-premium life insurance, endowment, and annuity contracts. You cannot deduct interest on money you borrow to buy or carry a single-premium life insurance, endowment, or annuity contract.

Used as collateral. If you use a single premium annuity contract as collateral to obtain or continue a mortgage loan, you cannot deduct any interest on the loan that is collateralized by the annuity contract. Figure the amount of interest expense disallowed by multiplying the current interest rate on the mortgage loan by the lesser of the amount of the annuity contract used as collateral or the amount of the loan.

Borrowing on insurance. Generally, you cannot deduct interest on money you borrow to buy or carry a life insurance, endowment, or annuity contract if you plan to systematically borrow part or all of the increases in the cash value of the contract. This rule applies to the interest on the total amount borrowed to buy or carry the contract, not just the interest on the borrowed increases in the cash value.

Tax-exempt income. You cannot deduct expenses you incur to produce tax-exempt income. Nor can you deduct interest on money you borrow to buy tax-exempt securities or shares in a regulated investment company (mutual fund) that distributes only exempt-interest dividends.

Short-sale expenses. The rule disallowing a deduction for interest expenses on tax-exempt securities applies to amounts you pay in connection with personal property used in a short sale or amounts paid by others for the use of any collateral in connection with the short sale. However, it does not apply to the expenses you incur if you deposit cash as collateral for the property used in the short sale and the cash does not earn a material return during the period of the sale. Short sales are discussed in chapter 4.

Expenses for both tax-exempt and taxable income. You may have expenses that are for both tax-exempt and taxable income. If you cannot specifically identify what part of the expenses is for each type of income, you can divide the expenses, using reasonable proportions based on facts and circumstances. You must attach a statement to your return showing how you divided the expenses and stating that each deduction claimed is not based on tax-exempt income.

One accepted method for dividing expenses is to do it in the same proportion that each type of income is to the total income. If the expenses relate in part to capital gains and losses, include the gains, but not the losses, in figuring this proportion. To find the part of the expenses that is for the tax-exempt income, divide your tax-exempt income by the total income and multiply your expenses by the result.

Example.

You received $6,000 interest; $4,800 was tax-exempt and $1,200 was taxable. In earning this income, you had $500 of expenses. You cannot specifically identify the amount of each expense item that is for each income item, so you must divide your expenses. 80% ($4,800 tax-exempt interest divided by $6,000 total interest) of your expenses is for the tax-exempt income. You cannot deduct $400 (80% of $500) of the expenses. You can deduct $100 (the rest of the expenses) because they are for the taxable interest.

State income taxes. If you itemize your deductions, you can deduct, as taxes, state income taxes on interest income that is exempt from federal income tax. But you cannot deduct, as either taxes or investment expenses, state income taxes on other exempt income.

Interest expense and carrying charges on straddles. You cannot deduct interest and carrying charges that are allocable to personal property that is part of a straddle. The nondeductible interest and carrying charges are added to the basis of the straddle property. However, this treatment does not apply if:

All the offsetting positions making up the straddle either consist of one or more qualified covered call options and the optioned stock or consist of section 1256 contracts (and the straddle is not part of a larger straddle), or
The straddle is a hedging transaction.

For information about straddles, including definitions of the terms used in this discussion, see chapter 4.

Interest includes any amount you pay or incur in connection with personal property used in a short sale. However, you must first apply the rules discussed in Payments in lieu of dividends under Short Sales in chapter 4.

To determine the interest on market discount bonds and short-term obligations that are part of a straddle, you must first apply the rules discussed under Limit on interest deduction for market discount bonds and Limit on interest deduction for short-term obligations (both under Interest Expenses, earlier).

Nondeductible amount. Figure the nondeductible amount of interest and carrying charges on straddle property as follows.

Add:
1. Interest on indebtedness incurred or continued to buy or carry the personal property, and
2. All other amounts (including charges to insure, store, or transport the personal property) paid or incurred to carry the personal property.
Subtract from the amount in (1):
1. Interest (including OID) includible in gross income for the year on the personal property,
2. Any income from the personal property treated as ordinary income on the disposition of short-term government obligations or as ordinary income under the market discount and short-term bond provisions — see Discount on Debt Instruments in chapter 1,
3. The dividends includible in gross income for the year from the personal property, and
4. Any payment on a loan of the personal property for use in a short sale that is includible in gross income.

Basis adjustment. Add the nondeductible amount to the basis of your straddle property.

How To Report Investment Expenses

To deduct your investment expenses, you must itemize deductions on Schedule A (Form 1040). Enter your deductible investment interest expense on Schedule A, line 13. Include any deductible short sale expenses. (See Short Sales in chapter 4 for information on these expenses.) Also attach a completed Form 4952 if you used that form to figure your investment interest expense.

Enter the total amount of your other investment expenses (other than interest expenses) on Schedule A, line 22. List the type and amount of each expense on the dotted lines next to line 22. (If necessary, you can show the required information on an attached statement.) Include the total on line 23 with your other miscellaneous deductions that are subject to the 2% limit.

For information on how to report amortizable bond premium, see Bond Premium Amortization, earlier in this chapter.

When To Report Investment Expenses

If you use the cash method to report income and expenses, you generally deduct your expenses, except for certain prepaid interest, in the year you pay them.

If you use an accrual method, you generally deduct your expenses when you incur a liability for them, rather than when you pay them.

Also see When To Deduct Investment Interest, earlier in this chapter.

Unpaid expenses owed to related party. If you use an accrual method, you cannot deduct interest and other expenses owed to a related cash-basis person until payment is made and the amount is includible in the gross income of that person. The relationship, for purposes of this rule, is determined as of the end of the tax year for which the interest or expense would otherwise be deductible. If a deduction is denied under this rule, this rule will continue to apply even if your relationship with the person ceases to exist before the amount is includible in the gross income of that person.

This rule generally applies to those relationships listed in chapter 4 under Related Party Transactions. It also applies to accruals by partnerships to partners, partners to partnerships, shareholders to S corporations, and S corporations to shareholders.

The postponement of deductions for unpaid expenses and interest under the related party rule does not apply to original issue discount (OID), regardless of when payment is made. This rule also does not apply to loans with below-market interest rates or to certain payments for the use of property and services when the lender or recipient has to include payments periodically in income, even if a payment has not been made.

Chapter 3 - Investment Expenses