With the stock market heating up, you may have borrowed cash in 2003 for investment purposes or to buy stock on margin.
Of course, you'll want to maximize the write-off for your investment interest. But usually your investment interest deduction is capped at the amount of your total investment income.
One exception: If you make a special election, you can increase your write-off. The catch: You have to pass up the tax break for long-term capital gains.
Strategy: Calculate your tax bill both ways—with the special election and without. With no "right" or "wrong" way to handle the decision, it all depends on your taxable income, the amount of your investment interest expense and the amount of your income eligible for the new capital gains tax rate.
When all is said and done, you could discover your overall tax is lower if you forfeit the capital gains tax break. Here's the whole story:
Run the numbers both ways
You typically can deduct investment interest only up to the amount of your net investment income (i.e., interest income, plus short-term capital gains minus your investment expenses related to those income items).
If you don't have enough investment income in the current year, you carry over the excess amount of investment interest for possible deductions in future years when you do have enough investment income.
The investment income category does not include long-term capital gains resulting from the sale of stock or other investments unless you choose to forfeit the tax benefit of the capital gains rate.
If you elect to include long-term capital gains in your investment income, those gains are taxed at ordinary income rates (as high as 35 percent). And because of last year's tax law, the top capital-gains rate is 15 percent (20 percent for gains realized before May 5, 2003).
Furthermore, dividends realized in 2003 are also taxed at 15 percent. Before the 2003 tax act, dividends were taxed at ordinary income rates.
Sounds like a no-brainer, right? It's not. Despite the tax-law changes and lower rates, you still may come out ahead by making the tax-return election, as the example below illustrates.