Did you invest on margin in 2007? If so, you may face a difficult choice when preparing your tax return.
Problem: The interest you paid on a margin loan is only deductible against “net investment income." This income includes taxable interest and short-term capital gains. You also can elect to include qualified dividends and long-term capital gains.
However, if you elect to include qualified dividends or long-term gains, those gains will be taxed as ordinary income, at rates up to 35 percent. By not including them, they’ll be taxed no more than 15 percent.
Suppose your investment interest expense for 2007 was $4,000. Your net investment income from interest and short-term gains was $3,000 and you had $1,000 in qualified dividends and long-term capital gains.
* You can count your dividends and your long-term gains as investment income. This would permit you to deduct the entire $4,000 of investment interest but that $1,000 of dividends and long-term gains would be taxed at your ordinary income rate, not the bargain 15 percent tax rate.
* Your other choice is to exclude your dividends and long-term gains, which would then be taxed at only 15 percent. You’d still get a $3,000 deduction in 2007, for investment interest expense, and you’d carry forward the unused $1,000 on investment interest expense, for a future deduction.
The higher your ordinary tax rate and the greater your chance of deducting the carryforward in 2008, the more it makes sense to exclude your dividends and long-term gains from net investment income.
