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Saturday, January 1, 2011


By JC Leahy, MA Accounting

As you plan your income tax return, don't forget about money you have shelled out to buy, sell, and manage your investments. I like to divide investment-related expenses into 4 categories, all of which are treated differently on your tax return:

• Category I: Those that you just can't deduct
• Category II: Those that relate to buying and selling particular investments
• Category III: Those that relate to buying, selling, and managing your investments in general
• Category IV: Those that relate to royalty income and real estate rentals.


Costs specifically related to tax-exempt investments can't be claimed on your tax return at all. Congress' reason for making it this way is that if you're not going to have to include the income on your tax return, you shouldn't be able to include the deductions either. That makes sense.

However, here's one little point to remember: IRA's and 401k's and similar vehicles are NOT tax exempt!! They are tax DEFERRED. This means that outlays related to managing your IRA are, indeed, tax deductible if other requirements are met. On the other hand, outlays related to managing your tax-exempt municipal bonds are NOT.

Travel costs to attend an investment seminar, conventions, or stockholder meetings, or to investigate potential rental property are generally NOT tax deductible. Congress made it this way because they noticed that these activities so often occur in warm, sunny vacation locations. That makes a certain amount of sense.

Another investment related outlay that can't be deducted is one that you didn't pay. For example, if your brother Bob paid your annual IRA management fee, you can't deduct it. (Neither can your brother Bob, by the way.) That makes sense.

This leads to one important point of caution, however. If, Bob doesn't pay that IRA management fee, and the IRA management company simply takes it out of your IRA account, you can't deduct it. Why? Because technically, although you control your IRA, you don't own it; it is owned by a trustee. Therefore, if the fee is simply deducted from your IRA account, YOU didn't pay it! Always pay your IRA related expenses from a source outside the IRA; that way they will be deductible!!

Another expense that you just can't deduct is any part of the basic monthly fee for the first telephone line in your house.


Outlays related to buying any investment are capitalized as part of the investment, increasing its cost basis. This reduces the amount of any gain when you sell the asset.

Outlays related to selling any investment are subtracted from the selling price, reducing it to the "net amount realized." Again, this lowers the amount of any taxable gain when you sell the asset.


Unless you're a "real estate professional" or professional securities trader, which is pretty narrowly defined, all these expenses of owning and managing your investments go on Schedule A (Itemized Deductions) of your Form 1040 as "Miscellaneous Itemized Deductions" -- all except expenses related to royalties and real estate rentals, which go on Schedule E. We'll talk about Schedule E expenses later; let's focus on Miscellaneous Itemized Deductions for now. Almost anything you can think of could be included here as long as these conditions are met:

• You must itemize your deductions using Schedule A of Form 1040.
• You must literally "pay or incur" the expense yourself.
• The expense must be "ordinary and necessary."
• The relationship between the investments and the expense must be "reasonable and proximate."

Here's a partial list of deductions to think about:

* Fees for investment advice
* Subscriptions to investment or financial publications
* IRA setup and custodial fees
* Software or online services to manage your investments
* Safe deposit box fees if used to store investment related documents
* Transportation costs to and from your broker or advisor's office – including mileage
* Attorney, accounting, or clerical costs
* Charges for automatic investment services or dividend reinvestment plans
* Costs to replace lost security certificates
* Straight-line depreciation on your computer and peripherals to the extent they were used to manage investments
* Bank deposit losses if not FDIC insured
* Casualty or theft of non-rental, non-royalty investment property
* Investment fees for non-publicly offered mutual funds shown in Box 5 of Form 1099-DIV
* Proxy fight expenses related to non-frivolous policy disputes
* Salary of a bookkeeper, secretary, or other employee to keep track of investments
* Investment property management expenses
* Investment interest

Once you have compiled your list of Miscellaneous Itemized Deductions, the amount you can actually deduct is subject to a series of different limitations:

FIRST of all, the amount of any investment interest you are claiming cannot exceed the amount of investment income. If it does, the excess must be eliminated from your miscellaneous itemized deductions. This excess can be carried over and deducted on your tax return in some future year. There is no limit to the number of years you can carry it forward until you get a chance to use the deduction.

SECOND, most Miscellaneous Itemized Deductions, including investment expenses, are subject to a "2% of AGI Floor." This means that you multiply your adjusted gross income by .02 and subtract that figure from your investment expenses and other Miscellaneous Itemized Deductions.

The only people who don't have to worry about the 2% of AGI reduction are professional securities traders, who can put all their expenses on a Schedule C. These insiders have no reduction or limit on their investment expenses writeo-off at all. (Go figure!!!)

THIRD: If there is anything left after applying the first two limitations, it is subject to being reduced by a "phase out" of your total itemized deductions. Phase-out of miscellaneous itemized deductions occurs if your Adjusted Gross Income exceeds certain thresholds. These thresholds are:

If your filing status is "married filing separately" $79,975
Single $159,950
Head of Household $159.950
Married Filing Jointly $159,950
(2 Singles living together out of wedlock = $159,950 x 2 $319,900)
(Do you see the big marriage penalty in those numbers?)

Generally, for your 2008 return, 27% of itemized deductions above these thresholds evaporate in this sneaky Congressional take-back called the "phase-out" of itemized deductions. Gambling losses, medical expenses (minus 7.5% of AGI "floor"), and casualty/theft losses (minus a series of limitations that apply only to casualties and thefts) are not subject to "phase-out."

And again, there is no phase-out for the insiders who are able to list their investment expenses on Schedule C.

FOURTH: If there is anything left of your Miscellaneous Itemized Deductions at this point, it is now subject to the Alternative Minimum Tax -- which completely disallows all of your investment expense deductions.

It is not a wondrous shell-game that Congress hath wrought!!!!.


Royalty and real estate rental expenses, which appear on Schedule E, must meet the same requirements as the Schedule A expenses, namely:

• You must literally "pay or incur" the expense yourself.
• The expense must be "ordinary and necessary."
• The relationship between the investments and the expense must be "reasonable and proximate."

In order to limit the amount of royalty and rental expenses you can deduct, Congress came up with a scheme that classifies all income into 3 categories: "Earned Income," "Portfolio Income" and "Passive Income." . Earned Income includes wages and the net income (or loss) from conducting a business or a farm and certain other things like unemployment compensation. Any other income, in Congress' view, is "Unearned." Unearned income is divided into Portfolio Income and Passive Income. Portfolio Income is interest and dividends stocks, bonds, and bank accounts. Passive Income relates to things such as real estate rental and royalties. The tricky part about Passive Income is that if your expenses exceed your revenues, the resultant loss CANNOT be deducted unless you have another passive activity that is producing an equal profit – which is referred to as a "passive income generator," or PIG. In most cases, because of depreciation of high-cost assets such as buildings, rental activities generate only a small profit, or, more often, a nondeductible loss. This is to say that the deduction for passive investment expenses is limited to the amount of passive revenue. The excess can be carried over to future years until either the asset is sold, in which case the accumulated carried forward losses become part of a capital transaction, or a PIG comes along.

There is one important exception to the limitation of deducting real estate rental losses. If you have more than 10% of a real estate rental and you help manage it in a "active" way, and if your "Modified Adjusted Gross Income" is less than certain thresholds, you may use up to $25,000 of rental loss to offset other non-passive income, such as a salary. The thresholds are:

Married filing separately Zero
Married filing separately as abandonded spouses $50,000
(But the exception amount is $12,500 each, not $25,000)
Single $100,000
Head of Household $100,000
Married Filing Jointly $100,000
(2 Singles living together out of wedlock = $100,000 x 2 $200,000)
(Anybody see a marriage penalty in these numbers?)

Between $100,000 and $150,000, the $25,000 exception is phased down to zero.

Another exception relates to "qualified real estate professionals." These insiders can deduct their real estate losses fully every time without limit.


The bottom line to all of these complexities, is to keep careful track of all those investment related expenses and consult your tax advisor about how to best use them. For assistance with your income tax filings, you may wish to contact me:

JC Leahy, MA Accounting
JC Leahy & Company, LLC
dba Maximum Legal Refund (TM)
Taxes Minimized to Your Best Advantage (TM)
Tel. 301-537-5365

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