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Many people believe that interest paid relating to their securities brokerage margin account is automatically deductible, at least as investment interest expense. This just isn't true.

This has become an especially important issue relating to taxpayers who have employee stock options. Many employees are borrowing against their margin accounts to pay their income taxes and other personal expenses. Interest paid relating to funds used for income taxes and other personal expenses is not tax deductible, despite the fact the loan is secured by investment securities.

When we review tax returns prepared by new clients, we often find the interest deduction claimed relating to a margin account is in error.

There are four "hoops" to be cleared before margin interest qualifies for a tax deduction.

1. The interest must be paid. The amount disclosed on the year-end brokerage report as interest expense for the year is the amount charged to the account. Since virtually all individual taxpayers are on the cash basis, they must pay the interest in order to deduct it. When the same lender advances funds to pay interest, those amounts aren't deductible until they are repaid. You apply payments to the account first to any accrued interest. New clients often just report the total interest from their year-end brokerage report as investment interest expense, and they might have never made a payment to the account! Proceeds from the sale of securities are applied as payments to the margin account.
   
   (Planning note - if you are planning to deduct interest expense for your margin account, be sure it is paid by December 31.)
   
   
2. Interest is only deductible if it relates to loans for one of three items: (a) taxable investments, such as stocks, bonds or certificates of deposit, subject to the investment interest limitations, usually deductible on Schedule A or E; (b) trade or business expenditures; deductible on Schedules C, E or F, or (c) passive activity expenditures, such as for a rental property, subject to the passive activity loss limitations, usually deductible on Schedule E.
   
   When analyzing whether interest for a margin account is tax-deductible, you must allocate each interest payment to the amounts that it relates to, including non-deductible personal expenditures.
   
   
3. Interest is non-deductible when it is paid for debt obtained or continued in order to purchase or carry obligations that pay tax-exempt interest (mostly municipal bonds.) The IRS has ruled that when an investor who holds tax-exempt securities borrows money to purchase taxable securities, the interest with respect to the amount of the loan up to the value of the tax-exempt securities is non-deductible. This means the disallowance of interest expense for tax-exempt securities supercedes the regular tracing rules in computing the non-deductible amount.
   
   The amount that is non-deductible under this rule may be different for federal and state reporting. For state reporting, interest from U.S. Treasury obligations is usually tax-exempt, so the interest with respect to any amounts borrowed to purchase those securities would be non-deductible on the state income tax return. Also, some municipal bond interest may be subject to state income tax, so the interest attributable to those securities would be deductible on the state income tax return.
   
   To cap everything off, private activity municipal bonds are taxable for the federal alternative minimum tax, so interest attributable to those securities would be deductible for the federal alternative minimum tax. (Are you ready to pay off your margin account yet?)
   
   
4. Investment interest expense is only currently deductible up to the amount of investment income. Any excess amount is carried over to the next taxable year. Note the carryover amount may be different for federal regular tax, federal AMT, state regular tax and state AMT.
   
   Investment income generally includes taxable interest income, taxable dividends income that doesn’t "qualify" for taxation at long-term capital gains rates, short-term capital gains and taxable portfolio income. A taxpayer may elect to treat all or a portion of long-term capital gains as short-term capital gains, not eligible for the 15% maximum federal income tax rate and to treat dividends that qualify for taxation at long-term capital gains rates as not qualifying, in order to currently deduct investment interest expense. For 2008, the election is made at line 4.g. of Form 4952, Investment Interest Expense Deduction, and listed at line 5 of the Qualified Dividends and Capital Gain Tax Worksheet. When a taxpayer only makes long-term investments in growth stocks or stocks that pay qualifying dividends, it can be very difficult to use the investment interest deduction without making the election.

Principal payments may generally be allocated to the best tax advantage of the taxpayer. In other words, principal payments may first be allocated to amounts used to pay non-deductible personal expenses.

When you throw these tax accounting issues on top of the additional risk that you incur to be subject to margin calls, etc., margin accounts seem less attractive. In order to simplify your accounting, consider having two margin accounts - one for deductible interest and the other for non-deductible interest.

(The IRS has recently ruled that investment interest paid or accrued on indebtedness also allocable to property held for investment that is associated with a trade or business and passed through to a limited partner should be deducted on Schedule E and is not an itemized deduction. (Revenue Rulings 2008-12 & 2008-38.))

If you study these rules and follow them on a current basis, you will make your tax return preparer's job much easier and avoid an unpleasant surprise if you are ever audited.

For more articles and information about new tax developments, subscribe to our newsletter, Michael Gray, CPA's Tax & Business Insight by filling out the form below.

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Michael Gray, CPA

2482 Wooding Ct.

San Jose, CA 95128

(408) 918-3162

FAX: (408) 938-0610

email: mgray@taxtrimmers.com

Hours: 8am - 5pm PDT Monday - Friday

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