Investor Losses

<div class="Section1"><br /> <br /> Except as provided below, a passive activity includes any rental activity, without regard to whether the taxpayer materially participates in the activity.<a href="#_ftn1" name="_ftnref1">¹</a> A rental activity is any activity where rental payments are made principally for the use of tangible property.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> There are a number of exceptions to this rule. An activity is not treated as a rental activity if:<br /> <p style="padding-left: 40px;">(1)  the average rental period is less than eight days;</p><br /> <p style="padding-left: 40px;">(2)  the average rental period is less than 31 days and the owner of the property provides significant personal services in order to make it available for use by customers;</p><br /> <p style="padding-left: 40px;">(3)  the rental of the property is incidental to the receipt of personal services or to a nonrental activity;</p><br /> <p style="padding-left: 40px;">(4)  the taxpayer makes the property available on a nonexclusive basis during regular business hours;</p><br /> <p style="padding-left: 40px;">(5)  the taxpayer rents property to a pass-through entity engaged in a nonrental activity, in his capacity as an owner of that entity; or</p><br /> <p style="padding-left: 40px;">(6)  the personal use of a residence that is also rented out exceeds the greater of<br /> 14 days or 10 percent of the rental days.<a href="#_ftn3" name="_ftnref3">³</a></p><br /> <br /> <br /> <hr /><br /> <br /> <strong>Planning Point:</strong> For purpose of (2) above, in determining if a property owner's rental services are significant, all relevant facts and services—including the frequency of the services, type and amount of labor needed to perform them, and their value relative to the amount charged for the property's use—are taken into account.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> <hr /><br /> <br /> If an individual actively participates in a rental real estate activity subject to the passive activity rules, the individual may use up to $25,000 of losses and the deduction-equivalent of credits to offset nonpassive income. An individual need not actively participate in a rental real estate activity to obtain the $25,000 rental real estate exemption with respect to taking the low-income housing credit or rehabilitation tax credit.<br /> <br /> If the investment is in real estate which is not rental property, the real estate activity will generally be considered a passive activity subject to the passive loss rules unless the taxpayer materially participates in the activity. The $25,000 rental real estate exemption is not available with respect to nonrental property.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 469(c)(2).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 469(j)(8).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  Treas. Reg. § 1.469-1T(e)(3); IRC § 469(j)(10).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.  Temp Treas. Reg. § 1.469-1T(e)(3)(iv).<br /> <br /> </div>

<div class="Section1"><br /> <br /> If a taxpayer disposes of his interests in a passive activity in a fully taxable transaction, losses from the activity will receive <em>ordinary loss treatment</em> (i.e., they may generally be used to offset other income of the taxpayer) to the extent that they exceed net income or gain from all passive activities (determined without regard to the losses just discussed) for the year. This treatment applies both to current year losses as well as losses carried over from previous years, with respect to the activity disposed of. The IRS has been given the authority to issue regulations that will take income or gain from previous years into account to prevent the misuse of this rule.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> For the purpose of determining gain or loss from a disposition of property, the taxpayer may elect to increase the basis of the property immediately before disposition by an amount equal to the part of any unused credit that reduced the basis of the property for the year the credit arose.<a href="#_ftn2" name="_ftnref2">²</a> If the passive interest disposed of is sold under the installment method, previously disallowed passive losses are allowed as a deduction in the same proportion as gain recognized for the year bears to gross profit from the sale.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> If the disposition of the passive interest is to a related person in an otherwise fully taxable transaction, suspended losses remain with the taxpayer and may continue to offset other passive income of the taxpayer. The taxpayer is considered to have disposed of an interest in a transaction described in the preceding sentence when the related party later disposes of the passive interest in a taxable transaction to a party unrelated to the taxpayer.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> If the disposition is by death, the carried over losses may be deducted only to the extent the losses exceed the step-up in basis of the interest in the passive activity.<a href="#_ftn5" name="_ftnref5">⁵</a> If the disposition is by gift, the losses are not deductible. Instead, the donor's basis immediately prior to the transfer is increased by the amount of the disallowed losses allocable to the interest.<a href="#_ftn6" name="_ftnref6">⁶</a> However, where a donor makes a gift of less than his or her entire interest in property, a portion of the carried over losses is allocated to the gift and increases the donor's basis. A portion of the losses will continue to be treated as passive losses attributable to the interest that the donor has retained.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> If a trust or estate distributes an interest in a passive activity, the basis of such interest immediately before the distribution is increased by the amount of passive losses allocable to the interest, and such losses are never deductible.<a href="#_ftn8" name="_ftnref8">⁸</a><br /> <br /> A taxpayer is not treated as having disposed of the entire interest in an <em>activity</em> of a publicly-traded partnership until the taxpayer disposes of the entire interest in the partnership.<a href="#_ftn9" name="_ftnref9">⁹</a><br /> <br /> <hr /><br /> <br /> <strong>Planning Point:</strong> IRS Publication 925 (Passive Activity and At-Risk Rules) contains a number of examples of, and various scenarios relating to, passive activities and losses, and includes worksheets and filing instructions necessary for the completed reporting of passive activities.<br /> <br /> <hr /><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 469(g)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 469(j)(9).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 469(g)(3).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 469(g)(1)(B).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.  IRC § 469(g)(2).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.  IRC § 469(j)(6).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.  Sen. Rep. 99-313, 1986-3 CB (vol. 3) 713, 726.<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.  IRC § 469(j)(12).<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.  IRC § 469(k)(3).<br /> <br /> </div>

<p> <em>Editor's Note:</em> Under the 2017 tax reform legislation, individuals are no longer entitled to deduct casualty loss expenses as itemized deductions (when those losses are not related to property used in a trade or business) unless the casualty loss occurred in a federally declared disaster zone. This provision applies for tax years beginning after December 31, 2017. Under the 2025 OBBB, federal tax relief is also available with respect to disasters declared at the state level. </p><p> An exception to the passive loss restrictions is applied to certain casualty losses (<em><em>see</em></em> Q <a href="javascript:void(0)">8709</a> to Q <a href="javascript:void(0)">8721</a>) resulting from unusual events (including fire, storm, shipwreck, and earthquake). Losses from such casualties are generally not subject to the passive loss <br/> rules.<a href="#_ftn1">¹</a></p><p> Likewise, passive activity income does not include reimbursements for such losses if both of the following are true: <br/>(1) the reimbursement is includable in gross income under Treasury Regulation Section 1.165-1(d)(2)(iii) as an amount the taxpayer had deducted in a prior taxable year; and</p><p>(2) the deduction for the loss was not a passive activity deduction.</p><p> In other words, both the losses and the reimbursement should be taken into account in the calculation of the partnership's gross income, not its passive activity gross income.<a href="#_ftn2">²</a></p><p> The exception does not apply to losses that occur regularly in the conduct of the activity, such as theft losses from shoplifting in a retail store, or accident losses sustained in the operation of a rental car business.<a href="#_ftn3">³</a></p><p><hr align="left" size="1" width="33%"></hr></p><p> <a href="#_ftnref1">1</a>. Treas. Reg. §§ 1.469-2T(d)(2), 1.469-2(d)(2)(xi). </p><p> <a href="#_ftnref2">2</a>. Treas. Reg. §§ 1.469-2T(c)(7), 1.469-2(c)(7)(vi). </p><p> <a href="#_ftnref3">3</a>. TD 8290, 1990-1 CB 109. </p>

<div class="Section1"><br /> <br /> If a taxpayer has interest expenses that exceed his or her net investment income for the year, those expenses are considered excess interest and the deduction is disallowed. However, disallowed interest expenses from one year can be carried forward to the succeeding tax year.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> A taxpayer's investment interest expenses that are disallowed because of the investment income limitation in one year will be treated as investment interest paid or accrued in the succeeding tax year.<a href="#_ftn2" name="_ftnref2">²</a> The IRS has issued guidance that provides it will not limit the carryover of a taxpayer's disallowed investment interest to a succeeding tax year to the taxpayer's taxable income for the tax year in which the interest is paid or accrued.<a href="#_ftn3" name="_ftnref3">³</a> Prior to the issuance of this guidance, several federal courts had held that no taxable income limitation existed on the amount of disallowed investment interest that could be carried over.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 163(d)(2).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 163(d)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  Rev. Rul. 95-16, 1995-1 CB 9.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.  <em><em>See, e,g,</em></em>, <em>Sharp v. U.S.</em>, 94-1 USTC 50,001.<br /> <br /> </div>

<div class="Section1"><br /> <br /> The investment interest limitation is coordinated with the passive loss rules (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8695">8695</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8704">8704</a>), so that interest and income subject to the passive loss rules are not taken into consideration under the investment interest limitation.<a href="#_ftn1" name="_ftnref1">¹</a> Interest expense incurred to purchase an interest in a passive activity is allocated to that passive activity and is not investment interest.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> However, portfolio income of a passive activity and expense (including interest expense) allocable to it is considered investment income and expense, not passive income and expense.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> Investment interest expense and investment income and expenses do not include items from a trade or business in which the taxpayer materially participates.&nbsp;The IRS has determined that interest on a loan incurred to purchase stock in a C corporation was investment interest (where the purchaser was not a dealer or trader in stock or securities), even though the purchaser acquired the stock to protect his employment with the C corporation.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> In a decision citing Revenue Ruling 93-68, the&nbsp;Tax Court held that interest on indebtedness incurred to purchase a taxpayer&rsquo;s share of stock in a family-owned mortuary business was subject to the investment interest limitation, despite the fact that the taxpayer purchased the stock to conduct business full time and the fact that no dividends had been paid on the stock.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> Temporary regulations provide that, for purposes of the investment interest and passive loss rules, interest expense is generally allocated on the basis of the use of the proceeds of the underlying debt.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&sect;&nbsp;163(d), 469.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; Temp.&nbsp;Treas. Reg. &sect;&nbsp;1.163-8T(a)(4)(B).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect;&nbsp;469(e)(1).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; Rev. Rul. 93-68, 1993-2 CB 72.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; <em>Russon v. Commissioner,</em> 107&nbsp;TC 263 (1996).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> When determining whether a loss deduction will be allowed, the taxpayer must first apply the at risk rules. If a deduction is disallowed in one year under the at risk rules (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8689">8689</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8694">8694</a>), it generally cannot be deducted as a loss under the passive activity rules.<a href="#_ftn1" name="_ftnref1">¹</a>&nbsp;Therefore, the loss will be suspended under the at risk rules, and can be carried forward to the succeeding tax year if the taxpayer has sufficient amounts &ldquo;at risk&rdquo; in that later tax year.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; Temp.&nbsp;Treas. Reg. &sect;&nbsp;1.469-2T(d)(6)(i).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Losses and credits that are disallowed under the passive loss rules may be carried over to offset passive income and the tax attributable to this income in later years.<a href="#_ftn1" name="_ftnref1">¹</a> If passive losses (or credits) from a publicly traded partnership are carried forward, such losses (or credits) may only be offset by passive income (or tax attributable to passive income) from the same partnership.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Suspended losses and credits of an activity may also offset the income and tax of that activity when the activity ceases to be passive or there is a change in status of a closely-held corporation or personal service corporation. For a discussion of the treatment of losses allowed upon disposition of an interest in a passive activity, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8704">8704</a>.<br /> <br /> The rules relating to the treatment of suspended losses and credits when the activity is disposed of require that losses and credits carried over from year to year be traceable to a particular activity. Because of this, where there are losses or credits from two or more activities which, in the aggregate, exceed passive gains from other passive activities, the amount disallowed and carried over must be allocated among the different activities and between capital and ordinary loss. Disallowed passive losses are allocated among activities in proportion to the loss from each activity.&nbsp;The disallowed loss allocated to an activity is then allocated ratably among deductions attributable to the activity. Disallowed credits are allocated ratably among all credits attributable to passive activities.<br /> <br /> In identifying the deductions or credits that are disallowed, the taxpayer is only required to separately account for those items that, if separately taken into account by the taxpayer, would result in an income tax liability different from that which would result if such deduction were not taken into account separately. Deductions arising from a rental real estate activity, or in connection with a capital or IRC Section&nbsp;1231 asset, must be accounted for separately. Credits (other than the low-income housing or rehabilitation credits) arising from a rental real estate activity must also be accounted for separately.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> If an activity ceases to be passive (e.g., because the taxpayer begins to participate materially), its unused losses (or credits) from prior years continue to be passive, but may be used against the income (and tax liability) of that activity. If there is a change in the status of a closely-held C corporation or personal service corporation, its suspended losses from prior years will continue to be treated as if the status of the corporation had not changed.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;469(b).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;469(k)(1).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; Temp.&nbsp;Treas. Reg. &sect;&nbsp;1.469-1T(f).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRC &sect;&nbsp;469(f).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Special restrictions apply to publicly traded partnerships under the passive loss rules. A publicly traded partnership is a partnership that is traded on an established securities market or is readily tradable on a secondary market (or the substantial equivalent thereof).<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> The rules are applied separately to items attributable to a publicly traded partnership, meaning that income, losses, and credits attributable to the partnership may not be aggregated with other income, losses, and credits of the taxpayer-partner for purposes of the passive loss rules.<a href="#_ftn2" name="_ftnref2">²</a> Net passive loss from a publicly traded partnership will be treated as passive, while net passive income from a publicly traded partnership is to be treated as investment income.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> Generally, net passive loss from a publicly traded partnership is carried forward until the partner has additional passive income from the partnership or the partner disposes of the partnership interest. Also, the $25,000 rental real estate exemption (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8700">8700</a>) is available with respect to a publicly traded partnership only in connection with the low-income housing credit and the rehabilitation investment credit.<br /> <br /> Further, a taxpayer will not be treated as having disposed of the taxpayer&rsquo;s entire interest in an <em>activity</em> of a publicly-traded partnership until the taxpayer has disposed of the entire interest in the partnership. It would seem that if a publicly traded partnership is taxed as a corporation, the partnership is not a taxpayer subject to the passive loss rules.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;469(k).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;469(k)(1).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; Notice 88-75, 1988-2 CB 386.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRC &sect;&nbsp;469(a).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Yes, within limits. Because of the substantial tax benefits that can result when a taxpayer&rsquo;s interest expenses are large compared to the amount of income realized from the investments at issue, Congress has taken steps to limit the amount of investment interest that a taxpayer can deduct in any tax year.<br /> <br /> Therefore, a noncorporate taxpayer is permitted to deduct interest expenses incurred in funding the purchase of investment assets, but only to the extent that the taxpayer&rsquo;s interest expenses exceed net investment income (<em><em>see</em></em> below) for the year.<a href="#_ftn1" name="_ftnref1">¹</a> Any other investment interest expense is considered excess interest and is disallowed.<br /> <br /> &ldquo;Net investment income&rdquo; for purposes of the interest expense deduction means the excess of investment income over investment expenses.<a href="#_ftn2" name="_ftnref2">²</a> &ldquo;Investment income&rdquo; means the sum of the following four items:<br /> <p style="padding-left: 40px;">(1)&nbsp; Gross income derived from property held for investment <em>other than</em> gain derived from the disposition of that property (e.g., income from interest, dividends, annuities and royalties not derived in the ordinary course of the taxpayer&rsquo;s trade or business);</p><br /> <p style="padding-left: 40px;">(2)&nbsp; The excess, if any, of (i) &ldquo;net gain&rdquo; attributable to the disposition of property held for investment over (ii) the &ldquo;net capital gain&rdquo; determined by taking into account gains and losses from dispositions of property held for investment;</p><br /> <p style="padding-left: 40px;">(3)&nbsp; The taxpayer&rsquo;s net capital gain determined by only taking into account gains and losses derived from the disposition of investment property <em>or</em> the taxpayer&rsquo;s net gain attributable to disposition of property held for investment, whichever is lower, but only to the extent the taxpayer <em>elects</em> to treat such income as investment income for purposes of Section&nbsp;163; and</p><br /> <p style="padding-left: 40px;">(4)&nbsp; Qualified dividend income, to the extent the taxpayer elects to treat such income as investment income for purposes of Section&nbsp;163.<a href="#_ftn3" name="_ftnref3">³</a></p><br /> In other words, net investment income, for purposes of the interest expense deduction, generally does not include net capital gain from the disposition of investment property <em>unless</em> the taxpayer makes the election to do so (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8707">8707</a> for the tax consequences of this election).<br /> <br /> The term &ldquo;investment expenses&rdquo; means deductions (other than the interest deduction) that are directly connected with the production of investment income.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> The&nbsp;Tax Court has held that net gain for purposes of IRC Section&nbsp;163(d)(4)(B)(ii) means the excess (if any) of total gains over total losses, including capital loss carryovers, from the disposition of property held for investment.&nbsp;The Court further held that calculation of net gain required inclusion of the taxpayers&rsquo; capital losses and capital loss carryovers for purposes of calculating the IRC Section&nbsp;163(d)(1) limit on the investment interest expense deduction.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> The IRS has ruled privately that:<br /> <p style="padding-left: 40px;">(1)&nbsp; The term &ldquo;property&rdquo; (under IRC Section&nbsp;163(d)(5)(A)(i)) includes interest-free loans (which are deemed to yield gross income as a result of interest imputed under IRC Section&nbsp;7872) to a tax-exempt foundation;</p><br /> <p style="padding-left: 40px;">(2)&nbsp; Any imputed interest income that is deemed to be received by the taxpayer on the potential loan from the line of credit to the foundation is &ldquo;investment income&rdquo; (under IRC Section&nbsp;163(d)(4)(B)(i)); and</p><br /> <p style="padding-left: 40px;">(3)&nbsp; Any interest paid by the taxpayer on the line of credit used to make the potential loan to the foundation is &ldquo;investment interest&rdquo; (under IRC Section&nbsp;163(d)(3)(A)).<a href="#_ftn6" name="_ftnref6">⁶</a></p><br /> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8706">8706</a> for a discussion of the treatment of disallowed interest expenses and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8708">8708</a> for a discussion of how the interest expense deduction is impacted by the passive loss rules.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;163(d).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;163(d)(4)(A).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect;&nbsp;163(d)(4)(B).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRC &sect;&nbsp;163(d)(4)(C).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; <em>Gorkes v. Commissioner</em>,&nbsp;TC Summ. Op.&nbsp;2003-160.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; Let. Rul. 200503004.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> 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 <em>unless</em> the taxpayer elects to treat this income as investment income. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8705">8705</a>.<br /> <br /> 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&rsquo;s ordinary income tax rate for that tax year, rather than the special lower tax rates that otherwise apply to these types of income (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8605">8605</a> for a discussion of the currently applicable tax rates for capital gains and qualified dividend income).<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> 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.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> <em>Example:</em> 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 (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8706">8706</a>), if he does make the election, his investment income would equal $13,000 and he would only carry $2,000 forward.<br /> <br /> 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.<a href="#_ftn3" name="_ftnref3">³</a>&nbsp;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&rsquo; conclusion that the taxpayer had acted reasonably and in good faith, and that granting the extension would not prejudice the interests of the government.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> The elections are made on Form&nbsp;4952, &ldquo;Investment Interest Expense Deduction&rdquo; and may not be revoked for the year made, except with IRS permission.<a href="#_ftn5" name="_ftnref5">⁵</a>&nbsp;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).&nbsp;Therefore, allowing them to revoke their election did not prejudice the government or cause undue administrative burdens.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> 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.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.163(d)-1(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;163(d)(4).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.163(d)-1(b).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; Let. Rul. 200033020. <em><em>See also</em></em> Let. Rul. 200303013.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; Treas. Reg. &sect;&sect;&nbsp;1.163(d)-1(b), 1.163(d)-1(c).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; Let. Rul. 200146018.<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.163(d)-1(c).<br /> <br /> </div></div><br />