Deductible investment expenses fall into three basic categories:
(1) Expenses that are directly deductible against particular items of income, without reduction;
(2) Expenses of producing income that are taken as miscellaneous itemized deductions; and
(3) Investment interest expense.
The first category applies to rent and royalty income. Expenses attributable to rents and royalties may be deducted in full from gross income in computing adjusted gross income. The expenses are allowed whether or not the taxpayer itemizes deductions. Rental and royalty income and deductions are reported on Schedule E, Supplemental Income and Loss. The totals are then carried over to Form 1040, line 17 (note: references to particular line numbers in this article are to the 2011 Form 1040 since the IRS is not expected to release 2012 Form 1040 until late December, after Congress acts on 2012 legislation).
This first category also applies to direct costs from purchasing and selling stock (e.g. sales commissions) that are included in cost basis or deducted from amounts realized.
The second category applies to a host of expenses that may be related to investments and financial activities but do not necessarily relate to a particular investment. These expenses can be deducted as ordinary and necessary expenses incurred either for the production of income, or for the management, conservation, or maintenance of property held for the production of income. Examples include expenses for investment counsel, investment advice and management, custodial fees, office rent, clerical help, travel to broker’s offices and investment sites, bank fees and safe deposit box rentals, fees for IRAs, and subscriptions to investment-related publications.
This second category is included in miscellaneous itemized deductions on line 23 (other expenses) of Form 1040, Schedule A, Itemized Deductions (2011 form). Miscellaneous itemized deductions, together with unreimbursed job expenses and tax preparation fees, are only deductible to the extent their total exceeds two percent of adjusted gross income (line 38 of 2011 Form 1040). Most taxpayers will only choose to report their itemized deductions if they exceed the standard deduction, which for 2011 is $11,600, married filing jointly and qualified widow or widower; $8,500, head of household; and $5,800, single taxpayers or married filing jointly.
The third category is investment interest expense. Money borrowed to buy property that is held for investment is investment interest. The deduction is limited to net investment income, determined after deducting investment expenses, such as depreciation, that are directly connected with the production of the investment income. The deductible amount is calculated on Form 4952, Investment Interest Expense Deduction, and carried over to Line 14 (Interest You Paid) of Schedule A.
Taxpayers cannot deduct interest incurred to produce tax-exempt income. Investment interest does not include home mortgage interest or interest taken into account in computing income or loss from a passive activity.
As you can see, the deduction of investment expenses can be complex. Timing these expenses to align themselves with more comprehensive strategies, such as at year end, can create additional issues. If you have questions about the treatment of these expenses, please contact our office at (908) 725-4414