When to Take “Extra” Investment Interest?

I see many more farmers now with investment brokerage accounts.  Some of these farmers have borrowed against these accounts and the margin interest paid is considered investment interest and the tax deduction may be limited.

A farmer (or other taxpayer), trust or estate can deduct this interest only to the extent of net investment income.  This income is composed of:

• Taxable interest income,
• Annuity income,
• Net non-business royalty income,
• Certain oil and gas income,
• Dividend income (but not including qualified dividend income),
• Short-term capital gains, minus
• Expenses related to this income

For farmers to deduct this interest, they must have net investment income and itemize their deductions.  One option available is to elect to treat their qualified dividend income and long-term capital gains as “investment income”.  This allows the farmer to deduct more investment interest, however, the offset is that this income is now taxed as ordinary income.  The cost of making this election ranges from 10% to 20% depending on your tax bracket.  If you are in the 10 or 15% tax bracket, you should never make the election since those capital gains and qualified dividend income is taxed at zero anyway (unless you have a high state income tax rate).

Let’s look at a couple of examples:

Example 1 – Assume Farmer Brown has $30,000 of investment interest expense and had $8,000 of net investment income and $25,000 of long-term capital gains.  He is in the 35% tax bracket.  Currently, he is only allowed to deduct $8,000 and the remaining $22,000 is carried forward to the next year (you don’t lose the deduction, it is just deferred).  He can elect to treat $22,000 of his capital gains which reduces his tax bill by a net $3,300 ($22,000 X 35% = $7,700 savings less $22,000 X (35%-15%) increase in capital gains rate or $4,400 = $3,300).

Example 2 – Let’s assume that Farmer Brown knows he will have more than enough investment income next year.  In this case, he does not make the election, but rather he deducts the interest the following year when he saves $7,700 on his income taxes.

As you can see, making the election will cost you money, however, if you do not expect to have much investment income in the future or itemize your deductions infrequently, it may make sense to take the deduction now versus later (a tax bird in hand is worth two in the bush).

Paul Neiffer, CPA