A reader reminded us that our post from yesterday might be a little misleading. We discussed the deduction of investment interest and we led off with borrowing against stocks and mutual funds, etc. held in a brokerage account being investment interest. Unlike borrowing money against your home using a home equity line of credit secured by your home (subject to the maximum $100,000 borrowing tax limit), care must be taken when borrowing against investments to determine if it truly is investment interest. You must trace what the funds are used for and if this use is personal, then none of the interest is deductible.
For example, assume Farmer John has a brokerage account and borrows $25,000 against it to buy a new car for his child. Since the car is not used in the farm and is of a personal nature, none of the interest is deductible even though it was borrowed against investment funds. Conversely, if he borrowed this on his home equity line of credit, all of the interest would be deductible (as long as he did not exceed the $100,000 tax borrowing limit).
Also, if the investment account holds a fair amount of non-taxable municipal bonds and there are margin borrowings in the account to purchase additional investments, this is technically investment interest, however, part of the interest will be non-deductible due to the municipal bonds.
As you can see, this part of the tax law can get fairly complicated.
One more item is in regards to the basis reporting. We had a blog post on this a while back. One more gotcha from the new Proposed IRS Regulations deal with not reporting an asset on Form 706 (the estate tax return). If an asset is missing from Form 706 and is reported to the IRS before the statute of limitations expires, then the heirs are allowed to use that cost basis when selling the asset. However, if the missing asset is not reported in time, then the cost basis of the asset is zero. This can be bad news, but I can understand the position of the IRS. Either you pay the estate tax owed on the asset and get a cost basis equal to the value or if you don’t pay the estate tax owed, you get no cost basis.
As an example, suppose Jane passes away in 2016 worth $6 million. This is over the $5.45 million threshold, thus the estate is required to file Form 706. The executor files the form, but misses including a 40 acre parcel worth $400,000. If corrects the mistake in time and pays the $160,000 of additional estate tax, the heirs can sell it tax-free for $400,000. If not, the heirs will owe capital gains tax on the full sales price. If in a high tax such as California, the capital gains tax might come close to 40%.
Paul Neiffer, CPA