Dear Tax Talk,
I have a rather large amount of disallowed investment interest expense to be carried forward to 2008, accumulated through several years of obtaining loans to purchase stock in my previous employer’s stock purchase plan (employee-owned company).

I have since left the company, and had to sell back my shares in doing so. I would like to recapture the disallowed investment interest expense, but I currently do not have any investment income forthcoming. 

One thought I had is to borrow against my home (HELOC), and deposit the proceeds in a high interest-bearing savings account and/or CD. I would be able to deduct the HELOC interest, and the interest earned on the savings account and/or CD would end up being tax free up to the point that my disallowed investment interest expense carryover was used up. Am I crazy? Any other thoughts on the best way to recapture my disallowed investment interest expense?     

Dear Kevin,
Interest paid by a taxpayer is classified according to the use of the loan proceeds. There are numerous types of interest categories under the law.

Types of interest
  1. Business interest
  2. Passive activity interest
  3. Investment interest
  4. Mortgage interest
  5. Student loan interest
  6. Personal non-deductible interest

Interest paid can be allowed, limited, deferred, capitalized or denied. Business interest can be allowed, but sometimes it has to be capitalized. Mortgage and student loan interest are limited and the remainder denied. Investment interest can be limited and the balance deferred (it’s not right to call it “disallowed,” since really it is carried forward). 

Investment interest related to carrying tax-exempt investments is denied. Passive activity interest is similar to investment interest in that it may have to be deferred as part of the passive losses unless it first has to be capitalized. You see: You’re not crazy, the tax man is. 

Investment interest is interest paid on loans — the proceeds from which were used to purchase investments property. Property held for investment includes property that produces interest, dividends, annuities or royalties not derived in the ordinary course of a trade or business.

It also includes property that produces gain or loss (not derived in the ordinary course of a trade or business) from the sale or trade of property producing these types of income or held for investment (other than an interest in a passive activity).

Investment property also includes an interest in a trade or business activity in which you did not materially participate (other than a passive activity). A typical example of investment interest is a margin account with a broker.

The deduction for investment interest paid is limited to net investment income. This generally includes your gross income from property held for investment (such as interest, dividends, annuities and royalties), less investment expenses such as managed account fees.

It does not include qualified dividends or net capital gain unless you choose to include them. The reason is that qualified dividends and long-term capital gains are taxed at preferential rates. Investment interest is deducted at ordinary income tax rates. If you elect to forgo the preferential rate, you can offset these items of income with investment interest expense. This should lower your overall tax. The election is considered advisable when you will no longer own investment property.

You didn’t state what you did with the proceeds from the sale of your employer securities. If invested, the proceeds should be generating investment income that can be offset by your interest expense carry-forward. 

The whole HELOC investment strategy depends on what you can borrow at versus what your return is and your marginal rate. Suppose you’re in a 30-percent combined federal and state marginal tax bracket. If you pay $100 interest on the HELOC each month and earn $50 on the savings, you’ve lost $50. 

The earnings are sheltered by the investment interest expense carry forward, and your $100 HELOC deduction saves you $30 in tax. You’re still behind $20 — bad planning. It will only produce a tax benefit if the interest earned on the savings is 70 percent (that is 1 minus your marginal rate) or better than the interest rate paid on the HELOC. The $100 of HELOC interest is not deductible for AMT, which can practically eat up all your $30 savings.

Your best bet is to revisit the return for the year that you sold the stock and see if it behooves you to make the capital gain election offset against the disallowed investment interest. You should be able to amend the return, provided it is from 2005 forward or, if you had an extension, maybe even 2004.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.