Understanding The Timing Of Investment Expenses: Strategies For The Savvy Investor

Investment expenses are costs incurred by an individual or business in the pursuit of generating a financial return. These expenses can include interest on loans used to purchase investments, accounting fees, and investment advice fees.

The tax treatment of investment expenses varies depending on the jurisdiction and the type of investment. In the United States, for example, the Tax Cuts and Jobs Act (TCJA) of 2017 eliminated certain deductions for miscellaneous itemized deductions, which included investment-related expenses such as fees for investment advice and accounting costs. However, individuals may still be able to deduct investment interest expenses, which is the interest paid on loans used to purchase taxable investments. This deduction is limited to the individual's net taxable investment income for the year, and any leftover interest expense can be carried forward to future years.

It is important to note that not all investment expenses are tax-deductible, and the rules regarding deductibility can be complex. Consulting a tax professional is advisable to understand the specific tax implications of investment expenses in a given jurisdiction.

Interest on money borrowed to buy taxable investments

For the interest to be deductible, there must be a legal obligation to pay the interest. In other words, the lender must have the right to enforce payment of principal and interest on a loan. The interest will be deductible only if it is reasonable in the circumstances. In most cases, the reasonableness requirement will be fulfilled if the interest rate that applies to the borrower is the same as or similar to the market rate of interest that applies to borrowers with similar credit risks in similar circumstances.

The interest must also be incurred for the purpose of earning income from a business or property. More specifically, there must be a reasonable expectation of earning income at the time the investment was made with the borrowed funds. It is important to note that capital gains are not considered income. However, in the case of an investment such as mutual funds or securities, where the primary objective of borrowing is capital growth, it would be possible to deduct the interest as long as there is also an expectation to earn income (i.e. interest or dividends).

If an investment is made for both personal and business gain, income and expenses must be allocated proportionally.

Investment interest expenses

If an investment is made for both personal and business gain, income and expenses must be allocated proportionally. Investment interest expenses are tax-deductible in some circumstances, but not when used for passive ventures, such as investing in a business that the taxpayer owns but does not actively manage.

The amount that can be deducted is capped at the individual's net taxable investment income for the year. Any leftover interest expense is carried forward to the next year and can be used to reduce taxes in the future.

To determine the deductible investment interest expense, the individual's net investment income, which includes ordinary dividends and interest income, and their total investment interest expenses for loans used to purchase taxable investments, must be calculated.

For example, if an individual has $150,000 in total income, $8,000 in net investment income, $10,500 in investment interest expenses from a margin loan, and $13,000 in other itemized deductions, their taxable income is reduced from $150,000 to $129,000.

It is important to note that qualified dividends that receive preferential tax treatment are not considered investment income for these purposes. However, individuals can opt to have their qualified dividends treated as ordinary income, which may increase their investment interest expense deduction and result in a 0% tax on the dividends instead of the typical 15% or 20% tax rate.

Capital losses

A capital loss occurs when a security is sold for less than its original purchase price. In other words, it is the dollar amount difference when a security or investment is sold for less than what was paid for it.

There are three types of capital losses: realized losses, unrealized losses, and recognizable losses. Realized losses occur on the actual sale of the asset or investment. Unrealized losses are not reported. Recognizable losses are the amount of a loss that can be declared in a given year.

For tax purposes, capital losses are only reported on items intended to increase in value. They do not apply to items used for personal use, such as automobiles. Capital losses can be used as deductions on the investor's tax return, and they can be fully applied against future capital gains.

Any loss can be netted against any capital gain realized in the same tax year, but only up to $3,000 of capital loss can be deducted against earned or other types of income in the year. Remaining capital losses can then be deducted in future years, up to $3,000 a year.

For example, if an investor has a capital gain of $10,000 and a capital loss of $30,000, they can net $10,000 of their loss against their gain, but can only deduct an additional $3,000 of loss against their other income for that year. The remaining $17,000 of loss can then be deducted in future years, up to $3,000 a year.

Cost basis of investment

The cost basis of an investment is the original value or purchase price of an asset or investment for tax purposes. It is used to calculate capital gains or losses, which is the difference between the selling and purchase prices.

Calculating Cost Basis

The cost basis of any investment is equal to the original purchase price of an asset. If there are subsequent purchases, the need arises to track each purchase date and value. For tax purposes, the default method used by the IRS is the First In, First Out (FIFO) method. This means that when an investor sells, the cost basis on the original purchase is used first and would follow a progression through the purchase history.

Tracking Cost Basis

Tracking cost basis is required for tax purposes. It is also key to determining an investment's success. Brokerage firms offer cost basis tracking and report any necessary gains and losses to the IRS on Form 1099-B.

Cost Basis and Investments

The cost basis for different types of investments varies. Here are some examples:

• Stocks: The cost basis is the price paid per share plus fees per share. If dividends are reinvested, the cost basis is the price paid for the new shares.
• Mutual Funds: The cost basis is the price paid per share of the fund. If there are upfront "load charges", these can be added to the cost basis.
• Real Estate: The cost basis is the price paid for the property, plus the cost of any capital improvements made.

Cost Basis and Taxes

The cost basis is important for tax purposes as it is used to determine the capital gains tax rate, which is equal to the difference between the asset's cost basis and the current market value.

Cost Basis and Corporate Actions

Calculating the cost basis can become complicated due to corporate actions such as stock splits, dividends, and return of capital distributions. A stock split, for example, does not change the overall cost basis but the cost per share is divided by the share exchange ratio.

Investment advice fees

Percentage Fee

This is a common way for advisers to charge, where they take a percentage of the money you want advice on or that they manage. According to the Financial Conduct Authority (FCA), advisers typically charge an average of 2.4% of the amount invested for initial advice and 0.8% annually for ongoing advice.

Fixed Fee per Service

Advisers may charge a flat fee for specific services, such as consolidating pensions or investing. This option is often chosen by clients who only need help with a particular task and do not require ongoing advice.

Hourly Rate

Advisers may charge an hourly rate, which can range from £30 to £250 per hour, with the UK average being around £150 per hour. This method can be beneficial for clients who only need advice for a short period of time.

It is important to note that the fees charged by financial advisers are not standardised and can be negotiated. When seeking investment advice, it is recommended to get quotes from multiple advisers and understand their charging structure before engaging their services.

Frequently asked questions