8707 / In calculating the allowable investment interest deduction, what are the tax consequences when a taxpayer elects to treat all or a portion of capital gain or qualified dividend income as investment income?

Net investment income, for purposes of the interest expense deduction, generally does not include net capital gain from the disposition of investment property or qualified dividend income unless the taxpayer elects to treat this income as investment income. See Q 8705.

If the taxpayer makes this election, any net capital gain or qualified dividend income treated as investment income is not eligible to be taxed at the capital gains rates and will be subject to the taxpayer’s ordinary income tax rate for that tax year, rather than the special lower tax rates that otherwise apply to these types of income (see Q 8605 for a discussion of the currently applicable tax rates for capital gains and qualified dividend income).¹

The advantage of making the election is that a taxpayer may increase the amount of investment income against which investment interest is deducted, thus receiving the full benefit of the deduction.²

Example: Shawn incurred $15,000 in interest expenses related to investment property in 2025. His investment income included $6,000 of interest income, $2,000 received as qualified dividends and a $5,000 net capital gain on the sale of securities held for investment. If Shawn does not elect to treat his income from net capital gains and dividends as investment income, his investment income is $6,000 (i.e., only the interest income he realized for the year). He would, therefore, have $9,000 of disallowed interest expenses for the year. While he could carry those expenses forward to 2026 (see Q 8706), if he does make the election, his investment income would equal $13,000 and he would only carry $2,000 forward.

The election to treat net capital gain and qualified dividend income as investment income must be made on or before the due date (including extensions) of the income tax return for the taxable year in which the net capital gain is recognized, or the qualified dividend income is received, respectively.³ The IRS has, however, privately ruled that a taxpayer was permitted to make a late election to treat capital gains as investment income based on the IRS’ conclusion that the taxpayer had acted reasonably and in good faith, and that granting the extension would not prejudice the interests of the government.⁴

The elections are made on Form 4952, “Investment Interest Expense Deduction” and may not be revoked for the year made, except with IRS permission.⁵ The IRS has ruled privately that certain taxpayers who were properly classified as securities traders were permitted to revoke their election because such gains should have been treated as investment interest anyway (based on their status as professional securities traders). Therefore, allowing them to revoke their election did not prejudice the government or cause undue administrative burdens.⁶

A taxpayer can elect to treat capital gain or dividend income as investment income in one year without any obligation to make the election in any other tax year.⁷