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Julie Welch Columns

How Interest Can Be Deducted When Money is Borrowed to Buy Investments

  • Written by Julie Welch, CPA, CFP

welch julieIf a taxpayer borrows money to purchase investments, such as mutual funds, bonds or stock, the interest paid on the loan can usually be deducted. There are two limitations, however, on the amount of interest that can be deducted. First, a taxpayer cannot deduct the interest on loans used to buy investments that produce tax-exempt income. In other words, if a taxpayer borrows money to buy a municipal bond, the interest paid on the loan cannot be deducted.

Second, a taxpayer’s investment interest expense deduction for the year cannot exceed the net investment income for the year. Net investment income is the amount of a taxpayer’s investment income over his or her investment expenses, other than investment interest expense, for the year. Investment income includes interest and short-term capital gains, however it does not include dividends that qualify for the special dividends tax rate. Investment expenses include amounts paid for investment advice, investment publications and safe deposit boxes. Investment expenses do not include brokers’ fees taxpayers pay when buying or selling stock. These are added to the cost of the stock and reduce the gain or increase the loss when the stock is sold.

If part of the interest a taxpayer pays is not deductible because it exceeds the investment income, the disallowed deduction is not lost. The amount can be carried forward to future years. The disallowed amount is then deducted in the year or years that the taxpayer’s net investment income exceeds his or her investment interest.



If your client has $2,000 of net investment income and $2,400 of investment interest expense, you can deduct $2,000 of investment interest. The $400 ($2,400 – 2,000) you could not deduct is carried forward to the following year.


Investment Expenses

In calculating net investment income, investment income is reduced only by the investment expenses you can deduct. If you cannot deduct investment expenses because of the 2% of adjusted gross income (AGI) floor for miscellaneous deductions, you do not need to reduce investment income by the expenses. In other words, the investment income is reduced only by expenses from which a taxpayer receives a tax benefit.


Your client has $1,800 of interest income and total AGI of $50,000. Your client borrows money from a broker to purchase stock. The investment interest expense is $1,700. The only miscellaneous expenses are $500 for investment publications. Although it appears that the net investment income is $1,300 ($1,800 – 500) and $400 ($1,700 – 1,300) of the investment interest expenses will be disallowed this year and carried forward, this is not correct.

Because miscellaneous expenses must exceed 2% of your client’s AGI, $1,000 ($50,000 x 2%), before he or she can take a deduction for the expenses, you cannot deduct the investment expenses. As a result, you do not have to reduce the investment income by the investment expenses. The net investment income is $1,800, so you can deduct the entire $1,700 of investment interest expense.


Qualifying Dividends and Long-Term Capital Gains

Qualifying dividends and long-term capital gains, including capital gain distributions from mutual funds, are not automatically included in investment income. You may elect to include qualifying dividends and long-term capital gains in the calculation of the net investment income. You may elect to include qualifying dividends and long-term capital gains in the calculation of the net investment income. If the election is made, qualifying dividends and long-term capital gains are taxed as they are ordinary income. In other words, the maximum 15% rate on qualifying dividends and long-term capital gains must be sacrificed to generate an investment interest expense deduction at ordinary rates.

Congress changed the law to prevent taxpayers from taking advantage of the difference in rates between ordinary income and long-term capital gains. Without the change, taxpayers could deduct interest expense at his or her ordinary tax rate of 25%, 28%, 33% and 35%. At the same time, taxpayers could have your qualifying dividends and long-term capital gains taxed at a 15% tax rate.

For the most part, planning with this election is straightforward. If the net investment income is more than the investment interest expense without including qualifying dividends and long-term capital gains, do not make the election to include long-term capital gains in investment income. This way the taxpayer benefits from the 15% maximum tax rate on the qualifying dividends and capital gains.

The difficult choice occurs when qualifying dividends and long-term capital gains are taxed at a rate lower than an ordinary tax rate. If a taxpayer’s investment interest expense deduction is limited because he or she does not have enough investment income, the taxpayer must choose between an investment interest expense deduction today or an investment interest expense deduction in a future year. The decision depends on the amount of qualifying dividends and long-term capital gain that will be taxed at the ordinary tax rate if the election is made; and the amount of interest deduction that will be lost this year and carry over to the next if the election is not made. The decision also depends on how much investment income is expected in the future.



Your client is in the 33% tax rate bracket, has an investment income of $2,000 and a long-term capital gain of $3,000. Itemized deductions include investment interest expense of $2,700.

If no election is made, your client will pay tax of $450 (15% x $3,000) on the long-term capital gain. There is no tax on the net investment income of $2,000 because it is offset by $2,000 of the investment interest expense. Your client has an investment interest expense. There is an investment interest expense carry-over of $700 ($2,700 – 2,000). The $700 carry-over could reduce tax by $231 ($700 x 33%) in the following year if there is enough investment income. If you make the election to tax $700 of the $3,000 long-term capital gain at ordinary rates, all of the investment interest expense is deductible in the current year. Your client pays tax of $345 (($2,000 + 700 – 2,700) x 33%) + (15% x 2,300 (the remaining long-term capital gain)) on the income. Your client saves $105 ($450 – 345) this year, but no longer has an investment interest expense carry-over. Thus, over the two-year period, your client may pay additional tax of $126 ($231 (savings by not making the election and using the investment interest carry-over next year)).

If you are certain your client’s investment income next year will be more than his or her investment interest expense and investment interest expense carry-over, you should not make the election. By making the election, you can deduct the investment interest expense this year when you know your client can take the deduction.

Julie Welch (Runtz) is the Owner of Meara Welch Browne, P.C. She graduated from William Jewell College with a BS in Accounting and obtained a Masters in Taxation from the University of Missouri-Kansas City. She serves as a discussion leader for the AICPA National Tax Education Program. She is co-author of 101 Tax Saving Ideas.

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Audits and Tax Return Retention

  • Written by Julie Welch, CPA, CFP

welch julie 16"How long should my client keep his/her tax returns and supporting documentation?” is a frequently asked question. The safe, quick answer is keep old tax returns, W-2s, and information with tax planning relevance permanently. Keep less important supporting documentation for seven years.

Generally, the IRS has three years from the due date of the return to audit and adjust the return. Similarly, your client has three years following the due date to amend his return.

The due date for your 2016 tax return was April 18, 2017. Even if you filed a return on March 1, 2017, the IRS has until April 18, 2020, to audit the return. You have until April 15, 2020, to amend the return. If you extend the due date of the return, the period of time the IRS has to audit your client’s return and the period of time you have to amend the return are also extended.

Sometimes the IRS has longer than three years to audit a return. For example, the IRS has six years to audit a return if a person fails to report over 25% of gross income. If a return is not filed, or a fraudulent return has been filed, the IRS can audit records for that tax year at any time.

Supporting documentation should be kept, including summaries, cancelled checks, receipts, and 1099s for at least the three years following the due date of the tax return. To be safe, many advisers recommend these records be kept for seven years.

Tax returns and W-2s should be kept permanently. Keeping a tax return permanently provides support if the IRS contends your client did not file a return or filed a fraudulent return. Furthermore, you may need to refer to an old return to obtain information about:

• Home purchases and sales

• Depreciation of a home office, rental property, or business equipment

• Individual retirement account (IRA) contributions

• The purchase price of stocks, bonds, and mutual funds

• The taxability of pensions and annuities

Keep W-2s permanently because they include important information about Social Security wages and withholdings and income tax withholdings. If you ever need to prove earnings or Social Security and Medicare contributions, you will have the records if W-2s are kept.

Supporting Documentation

Generally, most records can be destroyed after seven years. For tax planning support, however, there are countless situations when it is desirable to have records from earlier years. For example, when a client sells a home, it is necessary to calculate their gain. To calculate the gain, you need records of the cost of the home, improvements to the home, and depreciation of the home. For some people, this information may go back forty years or more. Furthermore, if you rolled over the gain on the pre-1998 sale of your prior home, it is necessary to have records for the prior home.

Another example of when earlier records are helpful is when your client sells mutual funds. There are several planning strategies you can use to reduce your client’s gain in this situation. To use them, however, it is necessary to have information about purchases, distributions, and sales from earlier years.

In summary, you should never throw out tax returns; W-2s, and records might have future tax relevance. In particular, you should keep all home records, brokers’ statements for securities you still own, and retirement plan information. You should keep other tax-related records for seven years.

NOTE: A current Earnings and Benefit Statement can be requested on the Internet at www.socialsecurity.gov. Earnings records should be verified frequently. Errors discovered after three years have passed are difficult to correct. Also, socialsecurity.gov can be used to get an estimate of future Social Security benefits based on an actual Social Security earnings record.

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Even A Nonworking Spouse Can Contribute $5,500 To An IRA

  • Written by Julie Welch, CPA, CFP

welch julie 16If your client is married and either that person or their spouse does not work, they may still be able to contribute to individual retirement accounts (IRAs). The annual maximum IRA contribution per person is $5,500 ($6,500 if you are 50+). The total contribution for a taxpayer and their spouse is the lesser of their combined earnings or $11,000. The maximum amount a taxpayer can put into each of their separate accounts is $5,500 ($6,500 if you are 50+).

Your client and their spouse file jointly and have an adjusted gross income of $50,000 for 2016: $500 from your client’s wages, $45,000 from the spouse’s wages and $4,500 from interest. The spouse may contribute $5,500 to an IRA and your client may contribute $5,500 to a spousal IRA.

With a Roth IRA, contributions are not deductible, but generally all money withdrawn from a Roth IRA is tax-free.

Your client may wish to contribute to a traditional IRA if he or she is ineligible to contribute to a Roth IRA due to the income limitations or if they want to deduct their IRA contribution. If a taxpayer is in the 28% tax rate bracket and makes a $5,500 deductible IRA contribution, the Federal tax savings is $1,540. The state tax is also reduced.

If a taxpayer is not eligible to make a Roth IRA contribution or a deductible IRA contribution, a nondeductible IRA contribution can still be made as long as the taxpayer or their spouse has earned income and is under age 70 ½ as of the end of the year for which the contribution is made. In some cases, depending on the taxpayer’s current and estimated future tax rate brackets, he or she may choose to make nondeductible IRA contributions rather than Roth or deductible IRA contributions. Also, once a traditional IRA contribution is made, it can be converted to a Roth IRA.

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Tactics to Use When Preparing 1040s

  • Written by Julie Welch, CPA, CFP

welch julie 16Be Alert for Digital Documentation

Now that companies are going digital, many W-2s and Form 1099s are available digitally. This is a blessing since they may be more readily available when they are needed. However, it puts a bigger burden on you to assure you have all of the information when preparing a tax return since it may not be in the stack of information provided by your client. A good practice is to watch for documentation from payors listed on the prior year return and ask the client about any new bank and investment accounts.

Learn the Theory By Preparing Tax Forms By Hand

Does anyone really prepare tax returns without using tax software anymore? There are so many complexities and computational issues to consider when preparing tax returns, that using tax software is almost a necessity. However, to gain a real understanding of a concept, actually preparing a few of the forms “by hand” provides you more insight and a better understanding of the law in that area.

Take Form 8960 for the net investment income tax as an example. The tax software will plug numbers in for you. However, you really need to read the form and understand all of the adjustments and exclusions to calculate the proper tax and keep clients from paying unnecessary amounts. Even preparing a Schedule D for capital gains and losses manually helps you understand the netting process and how any capital loss carryovers work. Really understanding how the form works generally helps you understand the law. This in turn helps you to be able to understand planning issues and make recommendations to your clients for minimizing taxes. However, preparing the actual tax returns using tax software is highly desired, especially since many tax software packages will provide helpful hints and diagnostics of items needing more attention.

Reconsider Filing Status and Exemption Deductions

Filing married, filing separately rather than jointly, filing as head of household rather than single, or letting a child claim the dependency exemptions may reduce the family’s overall taxes.

• If a married couple has significant medical expenses subject to the 10% of adjusted gross income (AGI) floor or unreimbursed employee business expenses subject to the 2% of AGI floor, filing separately may reduce the overall tax by lowering the floor for deductibility. A couple with $100,000 of AGI and medical expenses of $7,000 receives no tax benefit from their medical expenditures due to the $10,000 ($100,000 x 10%) floor. If the spouse who incurred the medical expenses had $30,000 of AGI, then that spouse could deduct $4,000 ($7,000 – ($30,000 x 10%)), saving the couple over $1,000 in tax.

• Head of household filing status does not require that one be a single parent. Providing over half the housing costs of a parent who does not live with the client or over half the costs of most dependent relatives who live with the client for more than six months is enough to obtain the increased deductions, lower tax rates and higher phaseouts allowed to head of household filers.

• If the AGI is over $155,650, a client may be receiving a reduced benefit from the exemption deduction for their children, and the client is receiving no benefit from the education credits the government allows. If the child provides over 50% of his or her support, allowing the client’s children to claim their exemptions, particularly if they are in college with over $15,000 of earned income, may increase the family’s overall cash flow. Additionally, this may help their higher education financial aid opportunities.

Taking advantage of these strategies requires thinking now about who should pay the medical or college costs, how much a child needs to earn and how much support needs to be provided to exceed the 50% requirement for the exemption deduction.

Look for special situations that might have beneficial tax treatment. Examples of special situations include the following:

• Ministers

• Self-employed individuals

• Real estate professionals Watch for things that aren’t on the tax return that should be.

• Required Minimum Distributions, - If a client is over age 70 1/2, be watching for Required Minimum Distributions or know why the client may not have any.

• Qualified Charitable Distributions – if someone over age 70 ½ made a qualified charitable distribution (QCD), be sure it is properly reported as a QCD and assure that no charitable deduction was taken for that amount.

• Energy credits – the residential energy credit of up to $500 in one’s lifetime was reinstated retroactively to the beginning of 2015 through 2016. Also, ask the client about remodeling or energy efficiencies they have made to their home.

Use available resources.

• www.irs.gov has forms, guides, frequently asked questions (FAQs) on many topics.

• Many vendors have checklists available to help guide the tax return preparation to be sure all items have been considered

Protect Yourself From Identity Theft

One of the big issues facing the IRS right now is identity theft and the related scams. As tax return preparers, we need to be vigilant in watching for any signs of theft or fraud. The IRS recently issued a warning for tax return preparers regarding a new phishing scheme that mimics software providers and tries to trick recipients into clicking on a bogus link.

Remember to Renew (or get) Your PTIN

Preparer tax identification numbers (PTINs) are required for anyone who prepares or assists in preparing federal tax returns for compensation. The renewal and annual payment can be made online.

These tactics can help when preparing individual 1040s.

Julie Welch (Runtz) is the Owner of Meara Welch Browne, P.C. She graduated from William Jewell College with a BS in Accounting and obtained a Masters in Taxation from the University of Missouri-Kansas City. She serves as a discussion leader for the AICPA National Tax Education Program. She is co-author of 101 Tax Saving Ideas.

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Contribute An Extra $1,000 to Your IRA and An Extra $6,000 to Your 401(k) if 50+

  • Written by Julie Welch, CPA, CFP

welch julieIf your client is age 50 or older, he or she may be able to contribute extra amounts to their retirement plan. While these are called “catch-up” contributions, a taxpayer is eligible even if he or she have always contributed the maximum amount.

The extra amount that can be contributed depends on the type of retirement plan. Here is the regular amount, the extra amount, and the total amount a taxpayer can contribute to their retirement plan if they are age 50 or older:

Year Regular Extra Total

2016 Individual Retirement Accounts (Traditional and Roth IRAs)

2016 $5,5000 $1,000 $6,500


2016 $18,000 $6,000 $24,000



2016 $12,500 $3,000 $15,500



A taxpayer must have at least as much earnings from their job or business as they contribute to their retirement plan. Also, the extra contribution can be made as long as the taxpayer will be age 50 or older sometime during that year.

You are 55, earn $35,000 from your job, and are single. If your employer has a 401(k) plan, you can contribute up to $24,000 for 2016. Additionally, you can contribute up to $6,500 to your IRA, which could be either a traditional IRA or a Roth IRA.


Julie Welch (Runtz) is the Owner of Meara Welch Browne, P.C. She graduated from William Jewell College with a BS in Accounting and obtained a Masters in Taxation from the University of Missouri-Kansas City. She serves as a discussion leader for the AICPA National Tax Education Program. She is co-author of 101 Tax Saving Ideas.

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