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Tax Breaks On Investment Expenses

06/19/08 11:42:43 AM PST
by Paul C. Adair

It's never too early or too late to start thinking about your taxes. Here's a start.

Traders spend hours determining the right markets and specific investments. They sweat over hitting the perfect entry and exit points, scraping to gain another percent or two of profit. Most traders worry about their gross investment return, but pay little attention to how much money they are allowed to keep. Even more important than gross return is your net return after taxes. In order to maximize your net return, it is important to decrease your tax bill to the minimum that you legally have to pay.

Uncle Sam wants you to succeed at investing. The more you make from your investments, the more taxes the government receives. Because of this, there are many benefits, such as credits and deductions, written into the tax code. This article is aimed at describing one such set of advantages aimed at investors.

Many people have their tax returns completed by a professional and don't really worry about the fine points of federal tax law. However, tax breaks are often missed either because the tax professional doesn't ask the right questions or because the taxpayer doesn't know what records to keep. In order to work most effectively with your tax preparer, it pays for the investor to be aware of the tax laws relating to investments.

This article describes many of the deductions that can be claimed, and therefore subtracted from taxable income, as investment expenses. To be claimed, the taxpayer needs to file the basic Schedule 1040, as opposed to 1040A or 1040EZ. In addition, the taxpayer needs to itemize deductions. The investment deductions are claimed on Schedule A (Itemized Deductions), under the section on Job Related Expenses and Certain Miscellaneous Deductions (for 2007, located on line 23).

There are two criteria for items that are allowed as deductible investment expenses. First, the expenses must be incurred in an attempt to generate income that is taxable by the US government. For example, fees associated with municipal bonds or mutual funds that invest in municipal bonds are not deductible. Note that you don't really have to make money on your investments to claim the expenses, but simply attempt to do so.

Second, if you are like the majority of taxpayers you use the cash accounting method. In this case, the expenses claimed for a specific tax year must be paid sometime during that particular year.

Miscellaneous Deductions
In order to claim your investment expenses, your total itemized miscellaneous deductions must exceed 2% of your adjusted gross income. Only those expenses over and above that 2% level can be deducted. Let's assume that your AGI is $100,000 and you have $3,500 in miscellaneous deductions. Only the miscellaneous deductions over and above $2,000 (2% of $100,000) can be claimed, giving you $1,500 ($3,500-$2,000) of claimable deductions. 

In its Publication 529, the IRS groups the Miscellaneous Deductions into three categories: unreimbursed employee expenses, tax preparation fees, and "other expenses." The first category, unreimbursed employee expenses, is very broad and includes such varied items as business travel, work uniforms, tools, union or professional organization dues, job education, professional journals, computer and cell phone depreciation, job search expenses, and malpractice insurance. You should become knowledgeable about the job-related expenses that apply to your career situation and keep good records of those expenses.

The second category, tax preparation fees, is basically money that you give to a professional tax preparer. Included are the costs that you paid for tax preparation software and any fees paid to file electronically.

The third category, "other expenses," includes investment expenses, the focus of this article. Also grouped in this category are items such as hobby expenses to the extent that they match hobby income, certain types of property losses as an employee, and appraisal fees for property contributed to charity or for claiming a casualty loss.

The IRS Publication 529, Miscellaneous Deductions, goes into detail on the various types of deductions you can claim (you can download the entire 23-page publication from We will not cover the noninvestment deductions in this article, other than to remind you that you should claim all of the other deductions to which you are entitled in order to help exceed the 2% AGI level.

Computer Expenses
Some of the biggest expenses for investors are computer related, and most are deductible. For example, you can depreciate the cost of your computer and related equipment to the extent that you use it for selecting and tracking your taxable investments. You can deduct the entire expense of your computer system over the course of five years. Your tax preparer can help with the depreciation calculations, as can most tax preparation software.

Internet access is invaluable for most investors. Did you know that you can deduct the expense of access to the extent that you use it to track your investments? For example, if you pay $430 a year to your service provider and use your Internet access exclusively for investment purposes, you can deduct the entire amount. Most people, however, use their access for other personal reasons. In that case, estimate the percentage of in-use time that your access is used to generate taxable income and multiply the yearly total by that amount.

Other deductible computer expenses include those used to select investments and to track the markets and individual investments. Subscription fees and software for online services such as advisory services, data and charting providers, and trading systems are all deductible.

Investment Advice
Investment advice takes many forms, including personal financial advisors, websites, newsletters, and books. Most expenses related to investment advice can be deducted as a miscellaneous deduction, subject to the 2% limitation.

If you use a financial advisor, the deductibility of fees for investment advice depends on how your advisor makes his or her money. For example, if you use a fee-only advisor, all of those fees can be deducted. You cannot, however, deduct the money paid to advisors who make their money by commissions only. Commissions increase the basis that you pay for a fund, stock, or option (and therefore lower your gains subject to tax) and so cannot be deducted. If your advisor makes money both by commission and by direct fees, only the direct fees can be deducted. 

Even transportation to and from your investment advisor's or broker's office is deductible. Your  mileage can be deducted at the 2007 rate of 48.5 cents per mile. The mileage rate is adjusted frequently, so check on the 2008 rate when doing your taxes for next year. The important thing is to keep good and accurate records of your mileage.

If you are invested partially in tax-exempt investments, any fees that can't be separated out should be prorated to cover only those related to your taxable income. For example, if your fee-only investment advisor makes you $100,000 in total income and 15% of that was from municipal bond interest, then only 85% of her fees would be deductible

As we discussed previously, web-based advisory services and newsletters are deductible. Also deductible are such services sent by telephone or mail. Subscriptions to investment-related newspapers or magazines such as Barron's, Investor's Business Daily, and of course, Technical Analysis of STOCKS & COMMODITIES are all deductible as investment expenses.

Any books pertaining to investing are also fully deductible. Sorry, but you can't take a deduction for your entire financial library amassed over the last 20 years. Again, the deductible expenses need to be incurred in the year for which you are claiming a deduction.

There is, however, one category of advice that cannot be deducted. In order to prevent investment deductions from being abused to pay for personal vacations, no expenses incurred from investment seminars and conventions or for travel to them can be deducted. For similar reasons, no expenses relating to the attendance at shareholder meetings may be deducted unless your involvement goes beyond simply owning shares in the company.

Account Fees
Various types of account fees are eligible to be deducted. For example, some investors have a fixed amount of money taken out of their paycheck or checking account each month to be invested in stocks, bonds, or mutual funds. Although most of these automatic investment plans (such as through a no-load mutual fund) involve no fees, some banks do charge for the service. The service fees that are associated with such an investment plan can be deducted.

Similarly, a stockholder in a company may elect not to receive dividends in cash, but to have those payments used to buy additional shares of stock. The fees associated with automatic reinvestment of stock dividends through a bank or corporation may be deducted.

Other types of account fees are variously called maintenance, custodial, or wrap fees. These consist of a fixed amount that you pay per period, usually annually, to an organization that handles your accounts. The fee for a wrap account can cover a number of services, including advisory, management, and a fixed amount for brokerage. Each of these fixed fees is deductible.

The maintenance or custodial fees for an IRA or Keogh plan are handled a little differently. If you have the money taken directly out of your account, your balance is reduced by that amount and the fee is not deductible. However, if you pay the fees directly with money that is not taken out of your retirement account, then the money can be deducted as an investment expense. 

Mutual funds can have a front-end load, a back-end load, a constant load, and 12b-1 fees. None of these fees are deductible as investment expenses. Neither are brokerage fees for buying and selling specific stocks. However, all of these fees help you to pay less net tax (and decrease your profit in the bargain!). For example, a broker's fee for buying a specific stock increases the purchase price and the broker's fees for selling the same stock decreases the sales price. Both fees act to lower your total gain for the round-trip transaction. 

On the topic of mutual funds, for all of the publicly traded funds, none of the investment expenses of the funds are deductible. Your share of the fund's expenses merely act to decrease the dividend per share and therefore, lower the taxes that you pay on your dividends. If you are invested in a nonpublicly traded fund, the investment expenses are reported to you by the fund and can be deducted.

Safety Deposit Boxes
One of the items frequently mentioned in discussions of deductible investment expenses is safety deposit box fees. You may deduct these expenses if the box is used to store stocks, bonds, or other documents related to taxable-income producing investments. If you also use the box for storing tax-exempt bonds, you must deduct the fees on a pro-rated basis.

Other Expenses
Few of us have such a complex investment life that we need to hire help to sort it out. However, some additional allowed deductions include the costs of clerical help, associated office expenses, and office rent that are used to collect taxable income. Also allowed are legal expenses that are involved in generating taxable income.

Doubling up
The deductions for investment expenses must be taken for the year in which the money was spent. It is difficult for most taxpayers to exceed the 2% limit for any particular tax year. It often helps to combine several years' worth of investment expenses into one year. For example, in a year for which you are targeting taking the deductions, pay for several years' worth of newsletter subscriptions. You could even pay ahead for financial planning fees. Taking as many of the other miscellaneous deductions as you are allowed in a particular year also will help you to get past the 2% limit.

If you are a daytrader, these rules don't apply to you. Your trading is considered a business and the rules are much more generous. For example, you can write off all investment expenses as business expenses and those items are not subject to the 2% limitation. Your expenses are reported on Schedule C, Profit or Loss from Business, and directly decrease your trading income (or increase your reported trading losses).

The rules for being considered a trader are pretty nebulous, but stringent. The IRS definition of a trader is similar to the position of US Supreme Court Justice Stewart Potter when asked to define pornography: "I know it when I see it." For example, you need to be able to show a great deal of short-term trading activity. You need to be trying to profit from short-term market swings rather than from appreciation, dividends, or interest. Both the amount of time you spend on trading and the degree to which you rely on the trading income for a living are taken into consideration. The tax-detailed ramifications of daytrading are beyond the scope of this article.

Your entitlements
A large number of deductions are allowed for investment expenses. Taking advantage of these tax breaks can help to increase your net investment profit. Be aware of these, keep good records, and work with your tax preparer to make sure that you claim all of the deductions to which you are entitled.

Suggested reading
IRS Publication 550, Investment Income and Expenses
IRS Publication 529, Miscellaneous Deductions

Paul C. Adair

Paul C. Adair is a tax professional and long-time investor. He has a doctorate in chemistry from the University of Illinois and a bachelor's degree in chemistry from Indiana University.

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