Taxpayers Allowed Late Investment Interest Election

Originally Published on forbes.com on September 18th,2011

______________________________________

I’ve written on a similar ruling before, but another one has come up and it is worth repeating the lesson. Interest expense  falls into several categories each with its own set of rules on deductibility.  One of those is investment interest.  Investment interest is only deductible to the extent of investment income.  The computation of the limitation is done on Form 4952  To the extent investment interest exceeds investment income, the deduction is carried forward indefinitely.  Under the general rule, long term capital gain and favorably taxed dividends do not count as investment income.  I generally have a rule in tax matters not to comment on things making sense.  It is what it is.  Deal with it.  I’ll make an exception here and point out that without that rule there would be a tax arbitrage opportunity, because you would be getting an ordinary deduction for the investment interest possibly at 35% while they capital gains and dividends are taxes at 15%.  Holes like that quickly have trucks driving through them.

That rule presents a problem for someone who buys dividend paying securities on margin.  If the securites are generally held long term, there will never be any investment income under the general rule.  That creates tax arbitrage going in the other direction.  Income is taxed at 15% and deductions are deferred indefinitely.  Now the paternalist in me thinks maybe that is not such a bad thing, but the Tax Code should really be neutral about things like this.  It actually is.  You are allowed to elect to include capital gains and dividends in your computation of investment income.  The price you pay is giving up the favorable 15% rate on the income. 

Is the election a “no brainer” ?  Absolutely not.  Assuming you are like me and finally getting around to doing your extended 2010 return after having gotten the last K-1 you needed.  Last year you had $10,000 in investment interest and a $30,000 long term capital gain and no other investment income.  You can run your return with and without the election to see how much money it will save on the 2010 return.  I’m not going to give you some cute little formula.  Running the return with and without the election is the way to figure it.  Next you need to look at what has happened so far in 2011.  If in 2011 you have lots of short term capital gains, maybe you will get more benefit out of letting the deduction ride for a year.  If you notice, however, that Line 7 on Form 4952 (Disallowed Investment Interest to be Carried Forward) just keeps growing each year, you should consider the election.  It’s not a “no brainer”, but not considering it is a “no brains” maneuver.

Of course you may be like the people in PLR 201136005, who hired a professional to take care of these matters.  Here is what happened with them:

Taxpayers are a married couple filing a joint income tax return. Taxpayers engaged certified public accounting firm Preparer Firm to prepare their Year 2, Year 3 and Year 1 federal individual income tax returns. Taxpayers originally contemplated preparing their Year 1 individual income tax return using a purchased software package instead of using Preparer Firm. Preparer CPA 1 had provided accounting and tax services to Taxpayer 1′s father for a long time and in an e-mail to Taxpayer 1 dated Date 2, Preparer CPA 1 encouraged Taxpayers to again utilize Preparer Firm in the preparation of their Year 1 individual income tax return. Taxpayers subsequently decided to again utilize Preparer Firm and forwarded their tax return information to the Place A office of Preparer Firm on Date 3. Preparer Firm prepared the Year 1 return which was electronically filed on Date 4. The balance due was larger than Taxpayers expected. Taxpayers requested that Preparer CPA 1 and Preparer CPA 2 review the federal individual income tax return for Year 1. This review identified that Preparer Firm had failed to advise that Taxpayers make an election on Form 4952, Investment Interest Expense Deduction, to treat certain qualified dividend income as investment income. The return preparer did not advise Taxpayers to make the election. If the election had been made, the Federal income tax would have decreased by $a.

I have two quibbles with the fact pattern.  One is that you don’t have to be a CPA to screw up like that.  An EA or a regular preparer could foul up that way too.  The other is that I would never just advise you to make the election.  I would call you up and discuss it with you giving you the pros and cons.  I would tell you what the election would save on the return I was working on and await your instructions. 

You might wonder how this could be missed.  Although I can’t say for certain in this case, my educated guess is that the answer is software.  The default in the preparation software we use is to not make the election. I suspect that is fairly common.  It is not that the return without the election is wrong.  Whoever signed the return as preparer wasn’t doing anything that would generate preparer penalties.  Their firm was not providing good service.  I worry about both those things.  I probably worry about not provding good service a little more.  That’s just the way I was brought up.  We have professional responsibilities and we work for the clients.  The latter just feels more personal.

The good news for these taxpayers is that the IRS let them make a late election:

The information and representations made by Taxpayers establish that they acted reasonably and in good faith with this request. The affidavits presented show that they requested relief before the failure to make the election was discovered by the Service and they reasonably relied on a tax professional for the filing of their federal income tax return, however, the tax professional failed to make, or advise Taxpayers to make the election. The affidavits presented show that Taxpayers were unaware of the necessity for the election and, upon discovery of the error, promptly requested relief.

I suspect that the taxpayers probably did not personally bear the cost of getting the ruling.  If I am correct in that, they did get some benefit from using a CPA even one who turned out to not be providing great service.  If you have investment interest either from buying securities on margin or possibly from flow-through entities it could be worth your while to look at Form 4952 of your return and see if there is a big number on Line 7.  If there is you might want to look at whether the election might have helped you.  If it is a big enough number, it might be worth considering applying for your own ruling.