Save more on your taxes with this list of tax deductible investment expenses
Uncle Sam sure doesn’t make it easy to be an investor. He wants a cut of the profits but takes none of the risk.
He wants his cut up to an unlimited amount of gains but will only let you write off up to $3,000 in losses against other income.
Investing and tax planning have to go hand-in-hand or you’ll end up sharing a big portion of your gains while eating your losses alone.
Fortunately, there are a few tax breaks he’s allowed including tax-advantaged retirement plans such as 401(k)s and IRAs. If you make enough money, tax-exempt municipal bonds might even make sense against taxable bonds.
And don’t forget the lower rate for long-term capital gains and qualified stock dividends.
But the tax breaks don’t end there. The Internal Revenue Service will let you deduct certain investment expenses you incur on your taxable investments. It’s one of the most overlooked tax deductions among investors but could save you thousands next April.
Keep track of these tax-deductible investment expenses and don’t miss your opportunity to make Uncle Sam share in the costs.
- Investment-related miscellaneous itemized deductions
- Investment interest expense
- Capital losses
Tax Deductible Miscellaneous Investment-related Itemized Deductions
Miscellaneous itemized deductions are generally limited to the amount of expenses over and above 2% of your adjusted gross income (AGI). In other words, there’s a floor below which you lose the ability to deduct.
For example: Say your AGI is $75,000 and you have $3,000 in miscellaneous itemized deductions. Your 2% AGI floor in this case is $1,500 (2% of $75,000), so you lose the first $1,500 of the $3,000 you claim, but get to deduct the remaining $1,500.
Here’s a list of investment-related expenses that you may be able to deduct:
- Fees for investment counsel and advice, including subscriptions to financial publications
- IRA or Keogh custodial fees, if paid by cash outside the account
- Software or online services you use to manage your investments
- Safe deposit box rent, if you use the box to store certificates or investment-related documents
- Transportation to your broker’s or investment adviser’s office
- Attorney, accounting or clerical costs necessary to produce or collect taxable income
- Charges for automatic investment services and dividend reinvestment plans
- Costs to replace lost security certificates
Investment-related expenses that can’t be deducted include:
- Trading commissions—these are “capitalized” to increase your cost basis and/or reduce your taxable sales proceeds
- Costs of traveling to attend a shareholder’s meeting
- Investment advisory fees related to tax-exempt income—you generally need to prorate these fees based on the portion of tax-exempt investment income versus total taxable investment income
- Borrowing costs associated with life insurance
Many of these tax-deductible investment expenses aren’t going to be automatically tracked by your brokerage. You may also be paying them to multiple sources so it’s important to keep your own spreadsheet of investing expenses.
Investment Interest Expense Deduction
Investment interest expense is the interest on money you borrow to purchase taxable investments. For example, you can deduct the interest on a margin loan you use to purchase stock, but not if you use the margin loan to buy a car or tax-exempt municipal bonds.
I usually recommend against buying investments on margin because the downside risk is well beyond the potential gain. Borrowing money when you think you can earn a higher return sounds like a no-brainer but it also magnifies your losses. In fact, not buying on margin is one of my core Stock Market Basics.
That said, if you are going to buy stocks on margin, make sure you get the tax deduction for investment interest expense.
There’s a cap on deductibility equal to your net investment income, but any leftover interest expense can be carried over for future use, without expiration.
To calculate your net investment income—and therefore how much investment interest expense you can deduct—add up your taxable interest income, ordinary dividends and even long-term capital gains and qualified dividends if you make a special election to treat them as ordinary income. Then, subtract any investment-related miscellaneous itemized deductions you actually get to use.
For example, say you have
- $10,000 of investment interest expense,
- $10,000 of taxable investment income and,
- $5,000 of investment-related miscellaneous itemized deductions, $1,000 of which you can use given your AGI.
Your net investment income is $9,000 ($10,000 in investment income minus $1,000 in allowable investment-related miscellaneous itemized deductions). You could deduct a matching amount of investment interest expense or $9,000 for the current year. The remaining $1,000 of unused investment interest expense could be carried forward for potential use in future years.
How do the qualified dividend rules impact investment interest expense?
Qualified dividends. Qualified dividends that receive preferential tax treatment aren’t considered investment income for purposes of the investment interest expense deduction.
However, you could elect to treat qualified dividends as ordinary income (just as you can with net long-term capital gain income) to boost the amount you can deduct as investment interest expense. The concept here is that it’s better to pay 0% tax on qualified dividends than 15% or 20% tax.
Let’s go back to our example: If you also have $1,000 of qualified dividends, you could pay 15% (or 20%) tax on them, or you could elect to treat those dividends as ordinary income and boost your net investment income from $9,000 to $10,000—which means you could now deduct up to $10,000 in investment interest expense in the current year.
Payment in lieu of dividends. If you buy dividend-paying stock on margin and your broker lends out the stock, you don’t really receive dividends, you receive payment in lieu of dividends. These payments are treated as ordinary income and aren’t eligible for the qualified dividend rate. But the payments are eligible to offset your investment interest expense, so all is not lost.
However, if you already have sufficient ordinary investment income from other sources (or more payment in lieu of dividends than can be used), you’re stuck with ordinary tax treatment.
Capital losses and Tax Loss Harvesting
Capital losses can be used to offset capital gains without limit in any given year. If your capital losses exceed your capital gains, up to $3,000 in losses (or $1,500 each for married filing separately) could be used to offset ordinary income. Net losses of more than $3,000 can be carried forward to offset gains in the future.
Tax loss harvesting is an important strategy to lowering your tax obligation and some automated investing platforms are starting to rebalance portfolios automatically. The idea is to strategically match up your gains and losses each year.
- Before the end of trading each year, download your trades along with investments remaining in your portfolios
- Add up your capital gains already realized from the year’s transactions
- Calculate the unrealized gain or loss on investments you still hold
- Sell investments to book a loss that can be used to offset gains and potentially shield income from taxes
- Invest the proceeds in an exchange traded fund that tracks the sold investment’s sector or industry
- Make sure you wait at least 30 days if you are going to repurchase the particular investment you used for the tax loss
You don’t have to do tax loss harvesting at any particular point in the year. Watch your investments in the fourth quarter and consider selling just after earnings are reported. This will give you enough time that you can reinvest in the stock you sold before any significant news is scheduled.
Tax deductible investment expenses are some of the most commonly missed tax breaks but also some of the most important for investors. Don’t let Uncle Sam take part of the profits without also sharing in the risks and costs to your investment strategy.