Symmetry in the Concept of Deductible Investment Interest

Burgess J.W. Raby, Esq., and William L. Raby, CPA, of the Raby Law Office, Tempe, Ariz., discuss the implications of a recent case involving the investment interest limitation deduction of section 163(d) and advise tax practitioners to be familiar with these rules.

Document Type: Practice Articles

Tax Analysts Document Number: Doc 2002-23426 (5 original pages) [PDF]

Tax Analysts Electronic Citation: 2002 TNT 201-61

Citations: (15 Oct 2002)

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Burgess J.W. Raby, Esq., and William L. Raby, CPA, associated with the Raby Law Office in Tempe, Ariz., and contributing authors to Tax Notes' column Tax Practice and Accounting News, discuss the implications of a recent case involving the investment interest limitation deduction of section 163(d) and advise tax practitioners to be familiar with these rules.

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Originally enacted as part of the Tax Reform Act of 1969, section 163(d), Limitation on Interest on Investment Indebtedness, was designed to plug what many thought to be tax loopholes. Congress was concerned that individual taxpayers could engage in a type of tax arbitrage -- receiving an ordinary deduction for the interest they paid to carry investment property that would ultimately produce long- term capital gain rather than current income. A second perceived loophole was the mismatching of current ordinary interest deductions against future ordinary income, a grievous fiscal sin to those who believe that "a tax deferred is a tax avoided."

Thirty-three years later, the basic thrust of the code subsection remains unaltered, although the caption has been amended to read "Limitation on Investment Interest" while the body of the subsection has changed and details have been added. During that time, the tax environment has gone through numerous revisions -- including the retention of section 163(d) even after the Tax Reform Act of 1986 (TRA '86) eliminated special tax treatment of capital gains. It was as though the architects of TRA '86 knew that what they were doing to capital gains would really never survive and that special treatment for capital gains would again appear. We always have mismatching with us, of course, and the recent additions designed to control mismatching simply add to an already intricate tax law.

The investment interest allowed as a current deduction is the amount of the net investment income for the tax year. Net long-term capital gain on property held for investment is taken into account in calculating the amount of net investment income only if the taxpayer so elects, as will be discussed later. Since the enactment of section 163(d), however, there has been only one decided case, the 1987 Keating case, discussed infra, determining how capital loss carryovers into a given tax year affected the calculation of net investment income for that year and hence of deductible investment interest.

Concurring in Small Tax Case Classification

William Lenehan III, et ux. v. Commissioner, T.C. Summary Opinion 2002-124, Doc 2002-22402 (20 original pages) [PDF], 2002 TNT 192-10 (2002), might have been a case that could have set precedent for the handling of capital loss carryovers under the current version of section 163(d). But Lenehan involved only $6,062 and it was filed and decided as a small tax case, thus having no precedential value. Cases like Lenehan, however, that could be of precedential value, are among the types of cases Congress must have had in mind when it made the concurrence of the Tax Court necessary for a taxpayer to elect the small tax case provisions of section 7463. Lenehan really should have been a regular decision.

While Lenehan is not a published decision, Tax Court Special Trial Judge Robert N. Armen Jr. does provide a lengthy opinion in the case. However, we think that his explanation may prove more mischievous than helpful to practitioners, even though we have no complaint about the final deduction he allowed.

In the opinion, Judge Armen reviewed the legislative history of the statute and looked in standard law and general use dictionaries in a vain search for a definition of the terms "net gain" and "net capital gain." He did find "net loss" in the 7th edition of Black's Law Dictionary, defined as "[t]he excess of all expenses and losses over all revenue and gains." He then concluded that "as a matter of law . . . the term 'net gain' for purposes of section 163(d)(4)(B) means the excess, if any, of total gains over total losses from the disposition of property held for investment." This also is the definition used in the general instructions for line 4b on Form 4952, which is the form on which the investment interest limitation is calculated when filing a Form 1040.

Net Capital Gain

As originally enacted, section 163(d) did not include long-term capital gain as an element of investment income in calculating the limits on deduction of investment interest. The reason, of course, was that part of the rationale for having limits was to prevent the trade-off of long-term capital gain for an ordinary deduction of interest. This was changed in TRA '86, however, because that act eliminated rate differentials between ordinary and capital. It was again changed in the Revenue Reconciliation Act of 1993 to the current rule, which allows long-term capital gain to be considered as part of investment income to the extent that the taxpayer elects to treat that long-term capital gain as ordinary income. The impact of that election -- made by inserting an amount on Form 4952 -- is to include as investment income an amount of long-term capital gain, which is then taxed as ordinary income. While the return was for 1997, the Lenehans did not elect to include any of their long-term capital gain as investment income.

The Lenehans did report and use on Schedule D a long-term capital loss carryover of $141,621 which more than offset their $49,017 of short-term capital gain and $65,721 of long-term capital gains for the year and left them with $63,149 of remaining loss to carry over to 1998. The record does not indicate the year or years from which that loss carryover came; however, we do not think that the source year would matter here. While they netted the capital gains, both long- and short-term, against the capital loss carryover on Schedule D, the Lenehans did not net the capital loss carryover against the gains for purposes of the Form 4952 calculations. The IRS took exception to that.

Judge Armen noted that capital loss carryovers are treated as capital losses of the current year under section 1212(b). The petitioners had argued, said Judge Armen, that "section 163(d)(4)(ii) requires inclusion of only their short-term capital gains and, furthermore, that net gain and net capital gain do not require inclusion of their loss carryover." He rejected that argument, however, explaining that

[P]etitioners' reading of the statute is at odds with the plain language of the statute. Essentially, petitioners attempt to attach the phrase 'short-term gain' under the TRA 1976 amendment to the current definition of investment income, even though the phrase does not appear anywhere in section 163(d)(4)(B)(ii). If Congress intended investment income to include only short-term gain, the phrase 'short- term gain' would have remained in the definition of investment income, which it does not. If we were to adopt petitioners' reading of the statute, we would render meaningless Congress's explicit reference in section 163(d)(4)(B)(ii) to the terms 'net gain' and 'net capital gain'. Clearly, Congress did not intend this result, nor do we adopt it.

In turn, we beg to disagree with the possible implications if Judge Armen's comment above is taken out of context. The Lenehans did have short-term as well as long-term capital gain. To the extent that the capital loss carryover insulated the 1997 short-term gain from 1997 ordinary income tax, we would agree with Judge Armen that the capital loss carryover also must be used to reduce investment income. But since the Lenehans did not elect to include their long-term capital gain in the calculation of net investment income, the fact that the capital loss carryover more than fully offset that long-term capital gain should be irrelevant to the calculation of net investment income. Long-term capital gain has, in fact, been eliminated from the definition of "net investment income" unless the taxpayer elects to include it. As the conference report on the Revenue Reconciliation Act of 1993 explains,

The bill generally excludes net capital gain attributable to the disposition of property held for investment from investment income for purposes of computing the investment interest limitation. A taxpayer, however, can elect to include so much of his net capital gain in investment income as the taxpayer chooses if he also reduces the amount of net capital gain eligible for the 28-percent [now 20-percent] maximum capital gains rate by the same amount.

Judge Armen reached the correct conclusion as to the loss carryover reducing the short-term capital gain that was included in the Lenehans' net investment income calculation. But contrary to Judge Armen's explanation, Congress did intend in 1993 that only short-term capital gain be included in net investment income absent an affirmative election to include long-term capital gain. In the event of such an election, of course, any long-term capital gain that, in fact, was offset by a loss carryover would have to be reduced by the loss carryover that was utilized in that year.

Symmetry in Investment Income

The fact that those amounts of losses or deductions reducing current ordinary taxable income should be used to reduce net investment income can be illustrated by at least two examples involving investment expenses -- the 2 percent floor on miscellaneous deductions of section 67(a) and the treatment of nonbusiness bad debts set forth in Keating v. Commissioner, 89 T.C. 1071, Doc 87-7590 (1987), acq. 1989-31 IRB 4, 89 TNT 157-28 .

When Congress enacted section 67(a) as part of TRA '86, the conference report noted that "[i]n determining deductible investment expenses, it is intended that investment expenses be considered as those allowed after application of the rule limiting deductions for miscellaneous expenses to those expenses exceeding 2 percent of adjusted gross income." Why would this be? We think that it has been implicit in the concept of deductible investment interest from the beginning that net investment income would be reduced only by those items that also had the effect of reducing taxable income in that same year. The 2 percent does not effect such a reduction -- and hence does not reduce net investment income.

In the Keating case, a nonbusiness bad debt of $567,424, reported as a short-term capital loss, offset $116,800 of short-term capital gain, leaving $450,624 of capital loss carryover. The Keatings reduced their net investment income by, in effect, eliminating the $116,800 of short-term capital gain that the bad debt loss offset. The IRS disagreed and reduced net investment income by the full $567,424. Tax Court Judge Stephen J. Swift, however, concluded that "the amount or portion of nonbusiness bad debts that will be treated as investment expenses under section 163(d)(3)(C) . . . [should be] the amount thereof that is allowable as a deduction in the current year." He added that, "[i]f and to the extent nonbusiness bad debts that are not allowed as deductions in the current year become allowable as carryover deductions in later years, they would then become items of investment expense under section 163(d)(3)(C)." There are obvious similarities between Lenehan and Keating, since both involve the impact of capital loss carryovers on the calculation of net investment income, even though Judge Armen makes no reference to Keating in his Lenehan opinion.

Capital Gain Election

The election to treat some part of long-term capital gain as being subject to ordinary income tax rates seems at first glance to be more gesture than substance. But specific taxpayers do elect to take advantage of the election -- and some taxpayers, who have not made the election on their timely filed original returns, get permission for an extension of time to make the election. LTRs 200216012, Doc 2002-9502 (4 original pages) [PDF], 2002 TNT 77-24 , and 200238020, Doc 2002-21380 (3 original pages) [PDF], 2002 TNT 184-22 , are two rulings granting extensions.

In LTR 200216012, the firm preparing the taxpayer's return neither made, nor advised that person about the possibility of making, a capital gain election. The taxpayer read an article about the election and realized that he had had to forego current deduction of substantial amounts of net interest expense because of a lack of investment income, but that including his long-term capital gains as investment income would make enough interest expense deductible to more than offset the ordinary income treatment of the capital gain that would result. He brought the matter to the attention of the firm that had prepared his returns for the two years involved as well as for many earlier years. They told him that since the election must be made on a timely filed return, the only way he could now take advantage of it would be to file a request for permission to make a late election. They undoubtedly also explained to him that the unused investment interest carried over and could be used when he realized investment income in the future and that he would have to pay a filing fee to get a ruling. That, however, did not dissuade him, perhaps because he was not sure whether he would have investment income in the future, or because he realized marginal tax rates were dropping over the next few years compared to the tax years involved, or even perhaps because he was not sure if he would live that long. Or maybe he got the firm to pick up the costs of getting the ruling, since it was, after all, their failure to inform him of that possibility in the first place that made it necessary for him to be asking the IRS for permission to make a late election.

The ruling request recited that the failure to make the election was the fault of the return preparers, which was sufficient evidence under reg. section 301.9100-3(b)(1) that the taxpayer acted reasonably and in good faith. The taxpayer represented that granting the extension would not result in his having a lower tax liability in the aggregate for the two years involved than he would have had if the election had been timely made, and the IRS granted him an extension until 60 days following the date of the ruling.

LTR 200238020 dealt with a couple who wanted to make the capital gains election on their return for the year 2000 but could not get the numbers they needed from the lending institutions with whom they dealt to determine the amount of their investment interest. They did not receive information until November 2001, and the 2000 return finally was filed on January 10, 2002. Their second extension, however, had expired on October 15, 2001. They immediately requested a ruling granting them an extension of time for the capital gains election they had made on Form 4952 which, absent the extension, would not be valid since it was made on a return that was not timely filed. The IRS issued a ruling to the effect that the untimely election was acceptable.

Carryovers and "Solely Disallowed"

The amount of investment interest "allowed as a deduction under this chapter," according to section 163(d)(1), "shall not exceed the net investment income of the taxpayer for the taxable year." The amount not allowed as a deduction "by reason of" that limitation "shall be treated as investment interest paid or accrued by the taxpayer in the succeeding taxable year." As originally enacted, the section allowed a carryover of disallowed investment interest and defined disallowed investment interest as "the amount not allowable as a deduction solely by reason of the limitations" in the section. The change of language took place in TRA '86, but seems not to have been intended to have any substantive impact on the calculation of what was to be carried forward.

The old language, however, was the subject of a substantial amount of litigation, culminating in Lenz v. Commissioner, 101 T.C. 260, Doc 93-10298 (26 pages), 93 TNT 203-10 (1993), and Rev. Rul. 95- 16, 1995-1 CB 9, 95 TNT 34-9 . In Lenz, the Tax Court majority had repudiated an earlier opinion in Beyer v. Commissioner, 92 T.C. 1304 (1989), rev'd 916 F.2d 153 (4th Cir. 1990), in which the lower court held that a taxable income limitation applied to the carryover of investment interest under section 163(d). That is, the carryover of interest not deductible solely because of the limitation of section 163(d) implied that the interest to be carried over would have had the effect of reducing taxable income absent the limitation. But when the interest would have been of no tax benefit regardless of section 163(d), then no carryover was allowable. The argument was that section 163(d) was intended to be a limitation on deductibility and not intended to create a new deduction for carried over interest that, absent section 163(d), would not have been of any tax benefit in any year.

But in Rev. Rul. 95-16, the IRS conceded the issue in the face of adverse opinions from four appellate courts and the Tax Court. While the language of the statute changed a bit in 1986 on this point, and the decided cases all dealt with the prior language, the IRS concluded "the same result is appropriate under current section 163(d) . . . . This rule will apply to interest incurred both before and after section 163(d) was modified by the Tax Reform Act of 1986."


The investment interest deduction limitation added one more complication to the calculation of taxable income. While it put a ceiling on interest deductibility, it also created a new carryover, that of the investment interest disallowed under section 163(d). It did so even in those circumstances where the interest deductions would have been of no tax benefit even if section 163(d) had never been enacted.

In preparing returns on which section 163(d) limits the investment interest deduction, the calculation of the deduction for investment interest should always include consideration of whether the taxpayer can benefit in the current year by making the capital gain election. Tax working papers should indicate that a discussion was held with the client whenever the calculation shows a current benefit from making the election, even if the client decides against doing so. We have noted that in many tax preparation offices, the investment interest limitation on Form 4952 tends to be computer generated and subject to only cursory review, if that. Practitioners responsible for the returns should consider whether the results seem to reflect the internal logic and symmetry of section 163(d) and also whether they make sense in the context of the taxpayers involved.

Code Section: Section 163 -- Interest
Geographic Identifier: United States
Subject Area: Practice and procedure
Accounting periods and methods
Cross Reference:
Author: Raby, William L.; Raby, Burgess J.W.
Institutional Author: Tax Analysts