Kerri, a single taxpayer who itemizes deductions on Schedule A, incurs $12,750 o
ID: 2568839 • Letter: K
Question
Kerri, a single taxpayer who itemizes deductions on Schedule A, incurs $12,750 of interest expense on funds borrowed to acquire taxable bonds. Kerri also has $16,500 of taxable interest income for the year. Assume Kerri is in a 30% marginal tax bracket. How much of the interest expense can she deduct? Assuming the same facts except that the $16,500 of investment income is a qualifying dividend rather than taxable interest income, what should Kerry do if she wants to minimize her current year tax liability?
Explanation / Answer
If a taxpayer borrows money to purchase investments, like bonds, stocks or mutual funds, the interest paid on the loan can usually be deducted. The above statement has two exceptions: 1) a taxpayer can not deduct the interest on loans used to buy investments that produce tax exempt income and 2) A taxpayer’s investment interest expense deduction for the year cannot exceed the net investment income for the year.
In the present casae Kerry, as single taxpayer, incurs $12,750 of interest expense on funds borroed to acquire taxable bonds. She also has $16,500 of taxable interest income for the year.
She can avail itemized deduction on investment interest expense of $12,750 as she does not fall under any of the exemptions above. She can deduct whole of $12,750 against income of $16,500 and pay tax on $3,750 ($16,500 - $12,750) at the rate of 30%.
In case the investment income is a qualifying dividend rather than taxable interest income, the investment interest expenses will not offset against the same. The qualifying dividend will be taxable at a flat rate of 15%. So the tax liability will be $2.475 (15% of 16,500). The interest expense can be offset against any other income of Kerri other than qualifying dividend income and long term capital gain. If the same is not offseted it will be carry forwarded to the next year.
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