Investment Expenses

You can generally deduct the expenses of producing taxable investment income. These include expenses for investment counseling and advice, legal and accounting fees, and investment newsletters. These expenses are deductible as miscellaneous itemized deductions to the extent that they exceed 2% of your adjusted gross income. See chapter 3 in Publication 550 for more information.

Interest paid on money to buy or carry investment property is also deductible, but the deduction may be limited. See Limit on Investment Interest Expense, later.

Publicly offered mutual funds. Most mutual funds are publicly offered. Expenses of publicly offered mutual funds are not treated as miscellaneous itemized deductions. This is because these mutual funds report only the net amount of investment income after your share of the investment expenses has been deducted.

Nonpublicly offered mutual funds. If you own shares in a nonpublicly offered mutual fund during the year, you can deduct your share of the investment expenses on your Schedule A (Form 1040). Claim them as a miscellaneous itemized deduction to the extent your miscellaneous itemized deductions exceed 2% of your adjusted gross income. Your share of the expenses will be shown in box 5 of Form 1099-DIV. A nonpublicly offered mutual fund is one that:

1. Is not continuously offered pursuant to a public offering,
2. Is not regularly traded on an established securities market, and
3. Is held by fewer than 500 persons at any time during the tax year.

Contact your mutual fund if you are not sure whether it is nonpublicly offered.

Expenses allocable to exempt-interest dividends. You cannot deduct expenses that are for the collection or production of exempt-interest dividends. Expenses must be allocated if they were for both taxable and tax-exempt income. One accepted method for allocating expenses is to divide them in the same proportion that each type of income from the mutual fund is to your total income from the fund. To find the part of the expenses that relates to the tax-exempt income, you must first divide your tax-exempt income by your total income. Then multiply your expenses by the result. You cannot deduct this part.

Example. William received $600 in dividends from his mutual fund: exempt-interest dividends of $480 and taxable dividends of $120. In earning this income, he had a $50 expense for a newsletter on mutual funds. William divides the exempt-interest dividends by the total dividends to figure the part of the expense that is not deductible. Therefore, 80% ($480 ÷ $600) of William's expense is for exempt-interest income. He cannot deduct $40 (80% of $50) of the expense. William may claim the balance of the expense, $10, as a miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income limit. That is the part of the expense allocable to the taxable dividends.

Limit on Investment Interest Expense

The amount you can deduct as investment interest expense may be limited in two different ways. First, you may not deduct the interest on money you borrow to buy or carry shares in a mutual fund that distributes only exempt-interest dividends. If the fund also distributes taxable dividends, you must allocate the interest between the taxable and nontaxable income. Allocate the interest as explained under Expenses allocable to exempt-interest dividends underInvestment Expenses, earlier.

Second, your deduction for investment interest expense is limited to the amount of your net investment income.

Net investment income. This is figured by subtracting your investment expenses other than interest from your investment income. For this purpose, do not include any income or expenses taken into account to figure gain or loss from passive activities.

Investment income. Investment income generally includes gross income derived from property held for investment (such as interest, dividends, annuities, and royalties). It generally does not include net capital gain derived from disposing of investment property. Nor does it include capital gain distributions from mutual fund shares. However, you can choose to include part or all of your net capital gain in investment income. For information on this choice, see chapter 3 of Publication 550.

Investment expenses. Investment expenses include all income-producing expenses relating to the investment property, other than interest expenses, that are allowable deductions after subtracting 2% of adjusted gross income. In figuring the amount over the 2% limit, miscellaneous expenses that are not investment expenses are disallowed before any investment expenses are disallowed.

For information on the 2% limit, get Publication 529, Miscellaneous Deductions. For more information on passive activity losses, get Publication 925, Passive Activity and At-Risk Rules.

Example. Jane, a single taxpayer, has investment income for the year of $12,000. Jane's investment expenses (other than interest expense) directly connected with the production of income were $980 after subtracting the 2% limit on miscellaneous itemized deductions. Jane incurred $12,500 of investment interest expense during the year. She had no passive activity losses. Jane figures net investment income and the limit on her investment interest expense deduction as follows:

Total investment income		$12,000
Subtract:	Investment expenses (other than interest)	-980
Net investment income		$11,020

For the year, Jane's investment interest expense deduction is limited to $11,020 (her net investment income). The disallowed interest expense of $1,480 ($12,500 - $11,020) can be carried forward to the following year as explained next under Carryover.

Carryover. You can carry forward to the next tax year the investment interest that you cannot deduct because of the limit. You can deduct the interest carried forward to the extent that your net investment income exceeds your investment interest in that later year.

Form 4952. Use Form 4952 to figure your investment interest expense deduction. For more information about investment interest expense, get Publication 550.

Comprehensive Example

Robert and Janice Martin have the following four sources of investment income to report on their 2002 tax return. Their Schedule D (Form 1040) is shown later.

1. $1,204 gain from the sale of 200 shares of Mutual Fund S on October 8, 2002. They received Form 1099-B, and they report the sale on Schedule D (Form 1040). Robert and Janice purchased these shares in 1988 at $10 each. They received some return of capital distributions in 1990, 1991, and 1999 that reduced their basis in the shares. In 2000 and 2001, the Martins reported undistributed capital gains that increased their basis in their shares. They received no distributions in 2002 before the sale.
2. $265 in ordinary dividends and $61 in capital gain distributions from Mutual Fund R. The capital gain distributions include $30 of qualified 5-year gain. The Martins received Form 1099-DIV showing these amounts. They report the capital gain distributions on Schedule D (Form 1040) because they have other capital transactions. They complete the Qualified 5-Year Gain Worksheet in the instructions for Schedule D. They report the ordinary dividends on line 9 of Form 1040. They do not report the ordinary dividends on Schedule B (Form 1040) because their total ordinary dividends were not over $1,500.

   Robert and Janice invested $3,800 in this fund in June 2002 and received 153.16 shares that cost $24.81 per share. They requested that all of their distributions be reinvested in more shares of the fund. On December 26, 2002, they acquired an additional 13.03 shares at $25.01 per share from their reinvested dividends.

3. $101 of exempt-interest dividends from Mutual Fund X. They receive a statement from the fund, and they report this nontaxable amount on line 8b of Form 1040. The Martins invested $2,600 in this fund in April 2000 and received 87.54 shares at $29.70 per share. They received exempt-interest dividends of $92 in 2000 and $107 in 2001.
4. $237 in ordinary dividends from 100 shares of common stock in Green Publishing Company. They received Form 1099-DIV, and they report the dividends on line 9 of Form 1040. Robert and Janice bought this stock in 1988 for $10.29 per share.

Mutual Fund Record. Robert and Janice keep track of all their basis adjustments on their Mutual Fund Record, shown later. They show the return of capital distributions and the undistributed capital gains from Mutual Fund S and the reinvested dividends from Mutual Fund R. They do not show the exempt-interest dividends from Mutual Fund X because those dividends do not reduce their basis in the shares.

The Martins keep this record with their mutual fund documents, and they use it to report their 2002 sale of Mutual Fund S.

Preparing Schedule D. The Martins use their Form 1099-B and their Mutual Fund Record to figure the gain from the sale of Mutual Fund S to report on Schedule D.

Robert and Janice enter the $61 capital gain distribution from Mutual Fund R (from box 2a of Form 1099-DIV) on line 13, column (f). They do not make an entry in column (g) of line 13 because Mutual Fund R did not indicate that any of the capital gain distribution was a 28% rate gain distribution (box 2b of Form 1099-DIV).

They enter the $30 qualified 5-year gain (from box 2c of Form 1099-DIV) on line 5 of the Qualified 5-Year Gain Worksheet in the instructions for Schedule D.

They report the sale of their shares in Mutual Fund S on line 8 because they owned the shares for more than 1 year. They use the information from their Mutual Fund Record to complete columns (a), (b), and (e). After adjustment for their return of capital distributions and their undistributed capital gains, their basis is $1,996 ($9.98 per share). They use their Form 1099-B to complete columns (c) and (d). Their sales price in column (d) (the gross proceeds shown in box 2 of Form 1099-B) is $3,200 ($16 per share). They enter their gain of $1,204 in column (f). They do not make an entry in column (g) because the gain was not 28% rate gain.

Because they owned their shares in mutual fund S for more than 5 years, the $1,204 gain is qualified 5-year gain. They enter $1,204 on line 1 of the Qualified 5-Year Gain Worksheet. They add the amounts on lines 1 and 5 of the worksheet and enter the total, $1,234, on line 6 and line 8 of the worksheet and on line 29 of Schedule D.

Robert and Janice add the amounts on lines 8 and 13 of Schedule D and enter their net long-term capital gain of $1,265 on line 16. They also enter that amount on line 17. Because lines 16 and 17 are gains, they compute their tax using Part IV of Schedule D. (Part IV is shown, but not filled in, except line 29 for reporting qualified 5-year gain.)

Qualified 5-Year Gain Worksheet

Schedule D, page 1

Schedule D, page 2

How To Get Tax Help

You can get help with unresolved tax issues, order free publications and forms, ask tax questions, and get more information from the IRS in several ways. By selecting the method that is best for you, you will have quick and easy access to tax help.

Contacting your Taxpayer Advocate. If you have attempted to deal with an IRS problem unsuccessfully, you should contact your Taxpayer Advocate.

The Taxpayer Advocate represents your interests and concerns within the IRS by protecting your rights and resolving problems that have not been fixed through normal channels. While Taxpayer Advocates cannot change the tax law or make a technical tax decision, they can clear up problems that resulted from previous contacts and ensure that your case is given a complete and impartial review.

To contact your Taxpayer Advocate:

• Call the Taxpayer Advocate at 1-877-777-4778.
• Call, write, or fax the Taxpayer Advocate office in your area.
• Call 1-800-829-4059 if you are a TTY/TDD user.

For more information, see Publication 1546, The Taxpayer Advocate Service of the IRS.

Free tax services. To find out what services are available, get Publication 910, Guide to Free Tax Services. It contains a list of free tax publications and an index of tax topics. It also describes other free tax information services, including tax education and assistance programs and a list of TeleTax topics.

Personal computer. With your personal computer and modem, you can access the IRS on the Internet at www.irs.gov. While visiting our web site, you can:

• See answers to frequently asked tax questions or request help by e-mail.
• Download forms and publications or search for forms and publications by topic or keyword.
• Order IRS products on-line.
• View forms that may be filled in electronically, print the completed form, and then save the form for recordkeeping.
• View Internal Revenue Bulletins published in the last few years.
• Search regulations and the Internal Revenue Code.
• Receive our electronic newsletters on hot tax issues and news.
• Learn about the benefits of filing electronically (IRS e-file).
• Get information on starting and operating a small business.

You can also reach us with your computer using File Transfer Protocol at ftp.irs.gov.

TaxFax Service. Using the phone attached to your fax machine, you can receive forms and instructions by calling 703-368-9694. Follow the directions from the prompts. When you order forms, enter the catalog number for the form you need. The items you request will be faxed to you.

For help with transmission problems, call the FedWorld Help Desk at 703-487-4608.

Phone. Many services are available by phone.
 
 

• Ordering forms, instructions, and publications. Call 1-800-829-3676 to order current and prior year forms, instructions, and publications.
• Asking tax questions. Call the IRS with your tax questions at 1-800-829-1040.
• Solving problems. Take advantage of Everyday Tax Solutions service by calling your local IRS office to set up an in-person appointment at your convenience. Check your local directory assistance or www.irs.gov for the numbers.
• TTY/TDD equipment. If you have access to TTY/TDD equipment, call 1-800-829-4059 to ask tax questions or to order forms and publications.
• TeleTax topics. Call 1-800-829-4477 to listen to pre-recorded messages covering various tax topics.

Evaluating the quality of our telephone services. To ensure that IRS representatives give accurate, courteous, and professional answers, we use several methods to evaluate the quality of our telephone services. One method is for a second IRS representative to sometimes listen in on or record telephone calls. Another is to ask some callers to complete a short survey at the end of the call.

Walk-in. Many products and services are available on a walk-in basis.

• Products. You can walk in to many post offices, libraries, and IRS offices to pick up certain forms, instructions, and publications. Some IRS offices, libraries, grocery stores, copy centers, city and county governments, credit unions, and office supply stores have an extensive collection of products available to print from a CD-ROM or photocopy from reproducible proofs. Also, some IRS offices and libraries have the Internal Revenue Code, regulations, Internal Revenue Bulletins, and Cumulative Bulletins available for research purposes.
• Services. You can walk in to your local IRS office to ask tax questions or get help with a tax problem. Now you can set up an appointment by calling your local IRS office number and, at the prompt, leaving a message requesting Everyday Tax Solutions help. A representative will call you back within 2 business days to schedule an in-person appointment at your convenience.

Mail. You can send your order for forms, instructions, and publications to the Distribution Center nearest to you and receive a response within 10 workdays after your request is received. Find the address that applies to your part of the country.

• Western part of U.S.:
  Western Area Distribution Center
  Rancho Cordova, CA 95743-0001
• Central part of U.S.:
  Central Area Distribution Center
  P.O. Box 8903
  Bloomington, IL 61702-8903
• Eastern part of U.S. and foreign addresses:
  Eastern Area Distribution Center
  P.O. Box 85074
  Richmond, VA 23261-5074

CD-ROM for tax products. You can order IRS Publication 1796, Federal Tax Products on CD-ROM, and obtain:
 

• Current tax forms, instructions, and publications.
• Prior-year tax forms and instructions.
• Popular tax forms that may be filled in electronically, printed out for submission, and saved for recordkeeping.
• Internal Revenue Bulletins.

The CD-ROM can be purchased from National Technical Information Service (NTIS) by calling 1-877-233-6767 or on the Internet at http://www.irs.gov/cdorders. The first release is available in early January and the final release is available in late February.

CD-ROM for small businesses. IRS Publication 3207, Small Business Resource Guide, is a must for every small business owner or any taxpayer about to start a business. This handy, interactive CD contains all the business tax forms, instructions and publications needed to successfully manage a business. In addition, the CD provides an abundance of other helpful information, such as how to prepare a business plan, finding financing for your business, and much more. The design of the CD makes finding information easy and quick and incorporates file formats and browsers that can be run on virtually any desktop or laptop computer.

It is available in March. You can get a free copy by calling 1-800-829-3676 or by visiting the website at www.irs.gov/smallbiz.

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