3 Things You Need to Know About Investment Income and Deductions

The tax code allows individuals a deduction for ordinary and necessary expenses paid in the year for the production or collection of income, or paid for the management, conservation, or maintenance of property held for the production of income, whether or not, in either case, they are business expenses. Personal management of one's investments is not the conduct of a trade or business. This is so without regard to the amount of time spent managing the investments or to the size of the portfolio.

The deduction applies to expenses in connection with both income and gain from sales. The deduction is taken by a cash method taxpayer in the year the expense is paid. This deduction is limited to expenses related to the production of income that is subject to federal income tax. However, it may be income realized in a prior year or anticipated in a subsequent year (as, for example, defaulted bonds bought with the expectation of gain on resale). The expenses are deductible even if no income is realized in the year. Expenses not for the production of income or the management, conservation, or maintenance of property held for the production of income, but paid in connection with activities carried on primarily as a sport or hobby may be limited.  Whether a transaction is carried on primarily for the production of income or for the management, conservation, or maintenance of property held for the production of income rather than primarily as a sport or hobby or recreation depends on the facts and circumstances involved.

To be deductible, expenses must be reasonable in amount and bear a reasonable and proximate relation to the production or collection of taxable income or the management, conservation, or maintenance of property held for the production of income.

Expenses that enter into the determination of income or loss of a passive activity are subject to the limitations of the passive loss rule and are not deducted as investment expenses. In general, a passive activity is any activity involving the conduct of a trade or business in which the taxpayer does not materially participate and any rental activity. Generally, an individual may deduct aggregate losses for the year from a passive activity only to the extent that they do not exceed aggregate income from passive activities in that year.

Expenses of a passive activity that are allocable to income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business are not treated as passive activity expenses, but rather are treated under the general rules applicable to other investment expenses.

Investment expenses are generally treated as miscellaneous itemized deductions. These expenses are, therefore, deductible from adjusted gross income only to the extent that the aggregate of all miscellaneous itemized deductions for the taxable year exceeds 2 percent of adjusted gross income. Only those investment expenses that are deductible (i.e., those remaining after the 2 percent floor has been applied) are considered in the calculation of net investment income.  For purposes of this calculation, the 2 percent floor is applied against all other miscellaneous itemized deductions before it is applied against investment expenses.

The more common expenses, provided they have the required relationship to the production of income (and deductible only to the extent that they exceed the 2 percent floor) include: (a) rental expense of a safe deposit box used to store taxable securities; (b) subscriptions to investment advisory services; (c) investment counsel fees; (d) custodian's fees; (e) services charged in connection with a dividend reinvestment plan; (f) service, custodian, and guarantee fees charged by the issuer of mortgage-backed securities, (g) bookkeeping services; (h) office expenses in connection with investment activities, such as rent, water, telephone, stamps, stationery, etc.; and (i) premiums paid for indemnity bonds required for issuance of new stock certificates to replace certificates mislaid, lost, stolen, or destroyed.

The Tax Court has denied a deduction for mutual fund shareholders' pro rata share of the annual operating expenses incurred by the mutual funds in which they owned shares. Because publicly offered mutual funds pass through income to shareholders on a net basis (i.e., gross income minus expenses), the Tax Court concluded that the shareholders had already received the benefit of a reduction in income for these costs and, therefore, were not entitled to deduct the operating expenses as investment expenses.

Partners in an investment club partnership formed solely to invest in securities and whose income is derived solely from taxable dividends, interest, and gains from security sales may deduct their distributive shares of the partnership's reasonable operating expenses incurred in its tax year that are proximately related to the partnership's investment activities. Operating expenses include postage, stationery, safe deposit box rentals, bank charges, fees for accounting and investment services, rent, and utility charges. Investment partnerships are not engaged in business because management of activities with respect to one's own account is not a trade or business.

Expenses may be nondeductible because they are personal in nature, or because they are not ordinary and necessary. Examples of such expenses would include: newspaper and magazine costs, where it is not clear that the publications were used principally for investment activities rather than personal activities; travel to attend shareholders' meetings; fees paid for maintenance of interest paying checking accounts where the fee is charged for the privilege of writing checks instead of maintaining the interest bearing account and the checks written are personal; travel expenses going to watch a broker's ticker tape regularly but not directly related to any particular transactions entered into for profit; maintenance of an art collection where personal pleasure, not investment, was the most important purpose for the collection; and expenses of maintaining a personal residence. An expense not otherwise deductible that is paid in contesting a liability against an individual does not become deductible simply because property held for production of income might have to be used or sold to satisfy the liability.

Expenses may be nondeductible because of other Internal Revenue Code sections. For example, expenses that are capital in nature are not deductible, such as broker's commissions and fees incurred in connection with acquiring property. These types of expenses are instead added to the basis of property. Similarly, selling expenses are offset against the selling price used in determining capital gains and losses, not deducted as expenses. A safe purchased to store property used in the production of income was ruled to be a capital expenditure. Expenses to defend, acquire, or perfect title to property are capital in nature. Legal expenses incurred to recover taxable interest and dividends are deductible, but portions allocable to the recovery of a capital asset (e.g., stock) are not deductible, but rather are capitalized. No deduction is allowed for expenses allocable to attending a convention, seminar, or similar meeting unless the expenses are ordinary and necessary expenses of carrying on a trade or business.

The Service has determined that a flat fee (representing a specified percentage of the market value of the assets in a taxpayer's account) that is paid to a stockbroker for investment services is not a carrying charge (under IRC Section 266) and, thus, cannot be capitalized. Instead, the Service stated, a flat fee is better viewed as a currently deductible investment expense.

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