Q:

Subject: Investment Interest

 

Dear Mr. Kerstetter,

 

I have client who set up a family limited partnership with his children. The Partnership invests primarily in vacant land, has some debt which generates

investment interest expense.

Occasionally, the Partnership sells some of the land at fairly large capital gains; however, there are not sales in every year so that in some years there is little or no income.

My question is: is it more advantageous to expense the investment interest as incurred and defer it to years when there are gains or to capitalize the interest to the cost of the underlying properties? For example, in 2004 each of the children has approximately $58,000 of capital gain income.

The children do not have any income or deductions other than that generated by the Partnership.

A:

As you obviously know, there is no universally best answer for this kind of thing. 

However, there are some key factors that you may want to consider.

Even if you enter the investment interest on the tax return each year, what will actually be deducted may be a small part of it, or even none at all, since the actual deduction is limited to the investment income reported on that year's 1040. Nondeductible interest carries over to future years where it can be claimed when there is sufficient investment income.

Another issue to consider is the different tax rates.  Capitalizing the interest would reduce the long term capital gain (LTCG), which is taxed at the lowest rates available (5% or 15%).  A deduction for investment interest could conceivably reduce the taxes by the normal marginal rate of up to 35%.

Based on just those points, it would most likely be advantageous to forgo capitalizing the interest (increasing LTCG) and entering the interest each year as potentially deductible investment interest.

There may be other factors peculiar to your situation that would warrant a different approach.

Good luck.  I hope this helps.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/16/2006 06:14:00 PM Send this post: