As you likely know by now, the Tax Cuts and Jobs Act (TCJA) reduced or eliminated many deductions for individuals. One itemized deduction the TCJA kept intact is for investment interest expense. This is interest on debt used to buy assets held for investment, such as margin debt used to buy securities. But if you have investment interest expense, you can’t count on benefiting from the deduction.

3 hurdles

There are a few hurdles you must pass to benefit from the investment interest deduction even if you have investment interest expense:

  1. You must itemize deductions. In the past this might not have been a hurdle, because you may have typically had enough itemized deductions to easily exceed the standard deduction. But the TCJA nearly doubled the standard deduction, to $24,000 (married couples filing jointly), $18,000 (heads of households) and $12,000 (singles and married couples filing separately) for 2018. Plus, some of your other itemized deductions, such as your state and local tax deduction, might be smaller on your 2018 return because of TCJA changes. So you might not have enough itemized deductions to exceed your standard deduction and benefit from itemizing.
  2. You can’t have incurred the interest to produce tax-exempt income. For example, if you borrow money to invest in municipal bonds, which are exempt from federal income tax, you can’t deduct the interest.
  3. You must have sufficient “net investment income.” The investment interest deduction is limited to your net investment income. For the purposes of this deduction, net investment income generally includes taxable interest, nonqualified dividends and net short-term capital gains, reduced by other investment expenses. In other words, long-term capital gains and qualified dividends aren’t included. However, any disallowed interest is carried forward. You can then deduct the disallowed interest in a later year if you have excess net investment income.

You may elect to treat net long-term capital gains or qualified dividends as investment income in order to deduct more of your investment interest. But if you do, that portion of the long-term capital gain or dividend will be taxed at ordinary-income rates.

Will interest expense save you tax?

As you can see, the answer to the question depends on multiple factors. We can review your situation and help you determine whether you can benefit from the investment interest expense deduction on your 2018 tax return. Call us today at 205-345-9898.

© 2019 Covenant CPA

Sometimes estates that are large enough for estate taxes to be a concern are asset rich but cash poor, without the liquidity needed to pay those taxes. An intrafamily loan is one option. While a life insurance policy can be used to cover taxes and other estate expenses, a benefit of using an intrafamily loan is that, if it’s properly structured, the estate can deduct the full amount of interest upfront. Doing so reduces the estate’s size and, thus, its estate tax liability.

Deducting the interest

An estate can deduct interest if it’s a permitted expense under local probate law, actually and necessarily incurred in the administration of the estate, ascertainable with reasonable certainty, and will be paid. Under probate law in most jurisdictions, interest is a permitted expense. And, generally, interest on a loan used to avoid a forced sale or liquidation is considered “actually and necessarily incurred.”

To ensure that interest is “ascertainable with reasonable certainty,” the loan terms shouldn’t allow prepayment and should provide that, in the event of default, all interest for the remainder of the loan’s term will be accelerated. Without these provisions, the IRS or a court would likely conclude that future interest isn’t ascertainable with reasonable certainty and would disallow the upfront deduction. Instead, the estate would deduct interest as it’s accrued and recalculate its estate tax liability in future years.

The requirement that interest “will be paid” generally isn’t an issue, unless there’s some reason to believe that the estate won’t be able to generate sufficient income to cover the interest payments.

Ensuring the loan is bona fide

For the interest to be deductible, the loan also must be bona fide. A loan from a bank or other financial institution shouldn’t have any trouble meeting this standard.

But if the loan is from a related party, such as a family-controlled trust or corporation, the IRS may question whether the transaction is bona fide. So the parties should take steps to demonstrate that the transaction is a true loan.

Among other things, they should:

  • Set a reasonable interest rate (based on current IRS rates),
  • Execute a promissory note,
  • Provide for collateral or other security to ensure the loan is repaid,
  • Pay the interest payments in a timely manner, and
  • Otherwise treat the loan as an arm’s-length transaction.

It’s critical that the loan’s terms be reasonable and that the parties be able to demonstrate a “genuine intention to create a debt with a reasonable expectation of repayment.”

If you’re considering making an intrafamily loan, contact us at 205-345-9898. We’d be pleased to answer any questions you may have.

© 2018 Covenant CPA