by George G. Jones and Mark A. Luscombe
Net capital gains, including qualifying dividends otherwise entitled to the new 15 percent maximum tax rate, may be included in investment income at the election of the taxpayer for purposes of computing how much investment interest he or she may deduct.
Making this election precludes the use of the lower tax rate attributable to that portion of the taxpayer’s net capital gain or dividend income so elected. Instead, she must treat that portion as ordinary income.
Usually, this election is not advisable. Yet, in some situations, the tax savings can more than make up for the energy spent incorporating the election into the client’s investment strategy.
Especially as 2003 ends, either recognizing or deferring capital gains and losses, investing or divesting oneself of dividend-paying securities, or otherwise modifying a portfolio’s income stream may make a significant difference.
A little now, or more later
The primary dilemma raised by the investment interest election stems from the ability of any unused investment interest deduction amount to be carried over, indefinitely, to future tax years. If it were not for this carryover feature, the decision to include net capital gains and dividends in investment income would be clear where excess investment interest otherwise existed: Either save nothing, or save the 15 percent otherwise due on the gain or dividend income.
Since the carryover option exists, however, the decision is more complicated. Basically, it comes down to an evaluation in which the time value of money must be weighed against expectations of realizing an excess amount of future investment income otherwise taxable at ordinary income tax rates.
This involves comparing the individual’s likely future income tax bracket (25, 28, 33 or 35 percent) to the 15 percent tax reduction presently available. It also involves anticipating whether, in fact, the near future will bring ordinary interest income that exceeds investment interest expense sufficient to soak up the carryover.
One alternative to waiting for future investment income-and-interest events to unfold, however, is to start molding investment and portfolio strategy now, to earn enough income that otherwise will be taxed at ordinary income rates.
This can be done quickly, to soak up the excess interest before 2003 ends, or perhaps more realistically in 2004 and 2005, to maximize use of the portion of the interest deduction that is carried over, rather than used in 2003 against more favorably taxed net capital gain or qualified dividend income.
One additional point to keep in mind when balancing a portfolio: While the investment interest deduction is limited to net investment income, no matching of interest and taxable income is required.
For example, margin interest incurred to buy stocks can offset bank interest (taxed at ordinary income rates), even though the stock purchase yields qualified dividend and capital gains taxed at 15 percent. As long as enough investment income is available to cover investment interest, the interest is deductible.
Two new issues
The time value of money considerations in place prior to the Jobs and Growth Tax Relief Reconciliation Act of 2003 - when the capital gains rate was 20 percent and dividends were taxed as ordinary investment income - continue to be the same. The only computational change is in the variables: a 15 instead of 20 percent capital gains rate, and a 25, 28, 33 and 35 ordinary income tax rate schedule, instead of 27, 30, 35 and 38.6 percent.
The decision whether to make the investment income election, however, is made a bit more complicated in 2003 because of staggered effective dates.
In 2003, net capital gain is taxed at 15 percent for post-May 5, 2003, transactions, and at 20 percent for pre-May 6, 2003, transactions. This creates two additional considerations for 2003 investors debating whether to make the election to convert gains or dividends into investment income taxed at ordinary rates:
● Does the taxpayer have the option to select net capital gain otherwise taxed at the 20 percent rate for ordinary income treatment, before using gain taxed at 15 percent?
● Does the taxpayer have the option of selecting net capital gain that may otherwise be taxed at 20, 25 or 28 percent, rather than selecting more favorably taxed qualified dividends for the investment income election?
Capital gains
Can the investment income election be made for 20 percent capital gain before it is made for 15 percent gain? While Code Section 1(h), as amended by JGTRRA, continues to prevent cherry-picking 28 or 25 percent gain property first in making the election, there appears to be no similar prohibition against reducing net capital gain attributable to 20 percent rate property (pre-May 6, 2003, transactions) before reducing net capital gain attributable to 15 percent rate sales.
This ability to increase the value of the election for 2003 net gain by a third (from 15 to 20 percent) may tip the scales in favor of making the election, rather than carrying forward an unused interest deduction.
Dividends
Net capital gain continues to be defined under Code Section 1223(11) as the excess of the net long-term capital gain for the tax year over the short-term capital loss for the year. While it is true that Code Section 1(h)(11)(A) now adds that, for purposes of determining the maximum capital gain rate (for capital gains and dividends), “net capital gains” means “net capital gain increased by qualified dividend income,” that addition does not foreclose flexibility to fine-tune an investment income election in 2003 to include or exclude qualified dividends.
Can dividend income be separated from an election to include net capital gain investment income? According to Code Section 163(d)(4), as amended, it can. Under JGTRRA, a taxpayer must specifically elect to include a dividend in investment income, or the Internal Revenue Service will assume that the reduced dividend rate applies and the dividend is excluded in calculating the maximum permissible investment interest deduction.
The taxpayer is free to decide, therefore, how much of his or her dividend income will be included in investment income and how much will be taxed under the 15 percent net capital gain rate.
This flexibility may be especially valuable for taxpayers with net capital gains taxed at 25 or 28 percent as Section 1250 recapture amounts or gain from collectibles. In those situations, dividends need not be selected to be reduced first, before 25 or 28 percent gain property may be offset through the investment interest deduction election.
Conclusion
At press time, Form 4952 (Investment Interest Expense Deduction) and its instructions had not been released for 2003 computations.
Besides waiting to see how the IRS will treat 15 and 20 percent capital gains for the purpose of the 2003 election, taxpayers and their advisors should also take the initiative.
By taking inventory of potentially deductible investment interest and likely investment income, with or without net gains or qualified dividends, the taxpayer can map out a proactive strategy.
Ideally, portfolio manipulation should cover anticipated deductible investment interest with enough ordinary income investment income to avoid any need, come tax filing season, to forego any of the added benefit in the new 15 percent rate on gains and dividends.
