Nondeductible Expenses

Some expenses that you incur as an investor are not deductible.

Stockholders' meetings.   You cannot deduct transportation and other expenses that you pay to attend stockholders' meetings of companies in which you have no interest other than owning stock. This is true even if your purpose in attending is to get information that would be useful in making further investments.

Investment-related seminar.   You cannot deduct expenses for attending a convention, seminar, or similar meeting for investment purposes.

Single-premium life insurance, endowment, and annuity contracts.   You cannot deduct interest on money you borrow to buy or carry a single-premium life insurance, endowment, or annuity contract.

Used as collateral.   If you use a single premium annuity contract as collateral to obtain or continue a mortgage loan, you cannot deduct any interest on the loan that is collateralized by the annuity contract. Figure the amount of interest expense disallowed by multiplying the current interest rate on the mortgage loan by the lesser of the amount of the annuity contract used as collateral or the amount of the loan.

Borrowing on insurance.   Generally, you cannot deduct interest on money you borrow to buy or carry a life insurance, endowment, or annuity contract if you plan to systematically borrow part or all of the increases in the cash value of the contract. This rule applies to the interest on the total amount borrowed to buy or carry the contract, not just the interest on the borrowed increases in the cash value.

Tax-exempt income.   You cannot deduct expenses you incur to produce tax-exempt income. Nor can you deduct interest on money you borrow to buy tax-exempt securities or shares in a regulated investment company (mutual fund) that distributes only exempt-interest dividends.

Short-sale expenses.   The rule disallowing a deduction for interest expenses on tax-exempt securities applies to amounts you pay in connection with personal property used in a short sale or amounts paid by others for the use of any collateral in connection with the short sale. However, it does not apply to the expenses you incur if you deposit cash as collateral for the property used in the short sale and the cash does not earn a material return during the period of the sale. Short sales are discussed in chapter 4.

Expenses for both tax-exempt and taxable income.   You may have expenses that are for both tax-exempt and taxable income. If you cannot specifically identify what part of the expenses is for each type of income, you can divide the expenses, using reasonable proportions based on facts and circumstances. You must attach a statement to your return showing how you divided the expenses and stating that each deduction claimed is not based on tax-exempt income.

One accepted method for dividing expenses is to do it in the same proportion that each type of income is to the total income. If the expenses relate in part to capital gains and losses, include the gains, but not the losses, in figuring this proportion. To find the part of the expenses that is for the tax-exempt income, divide your tax-exempt income by the total income and multiply your expenses by the result.

Example.   You received $6,000 interest; $4,800 was tax-exempt and $1,200 was taxable. In earning this income, you had $500 of expenses. You cannot specifically identify the amount of each expense item that is for each income item, so you must divide your expenses. 80% ($4,800 tax-exempt interest divided by $6,000 total interest) of your expenses is for the tax-exempt income. You cannot deduct $400 (80% of $500) of the expenses. You can deduct $100 (the rest of the expenses) because they are for the taxable interest.

State income taxes.   If you itemize your deductions, you can deduct, as taxes, state income taxes on interest income that is exempt from federal income tax. But you cannot deduct, as either taxes or investment expenses, state income taxes on other exempt income.

Interest expense and carrying charges on straddles.   You cannot deduct interest and carrying charges that are allocable to personal property that is part of a straddle. The nondeductible interest and carrying charges are added to the basis of the straddle property. However, this treatment does not apply if:

1. All the offsetting positions making up the straddle either consist of one or more qualified covered call options and the optioned stock or consist of section 1256 contracts (and the straddle is not part of a larger straddle), or
2. The straddle is a hedging transaction.

For information about straddles, including definitions of the terms used in this discussion, see chapter 4.

Interest includes any amount you pay or incur in connection with personal property used in a short sale. However, you must first apply the rules discussed in Short Sale Expenses under Short Sales in chapter 4.

To determine the interest on market discount bonds and short-term obligations that are part of a straddle, you must first apply the rules discussed under Deferral of interest deduction for market discount bonds and Deferral of interest deduction for short-term obligations (both under Interest Expenses, earlier).

Nondeductible amount.   Figure the nondeductible amount of interest and carrying charges on straddle property as follows.

1. Add:
   1. Interest on indebtedness incurred or continued to buy or carry the personal property, and
   2. All other amounts (including charges to insure, store, or transport the personal property) paid or incurred to carry the personal property.
2. Subtract from the amount in (1):
   1. Interest (including OID) includible in gross income for the year on the personal property,
   2. Any income from the personal property treated as ordinary income on the disposition of short-term government obligations or as ordinary income under the market discount and short-term bond provisions - see Discount on Debt Instruments in chapter 1,
   3. The dividends includible in gross income for the year from the personal property, and
   4. Any payment on a loan of the personal property for use in a short sale that is includible in gross income.

Basis adjustment.   Add the nondeductible amount to the basis of your straddle property.

How To Report Investment Expenses

To deduct your investment expenses, you must itemize deductions on Schedule A (Form 1040). Enter your deductible investment interest expense on line 13, Schedule A. Include any deductible short sale expenses. (See Short Sales in chapter 4 for information on these expenses.) Also attach a completed Form 4952 if you used that form to figure your investment interest expense.

Enter the total amount of your other investment expenses (other than interest expenses) on line 22, Schedule A. List the type and amount of each expense on the dotted lines next to line 22. (If necessary, you can show the required information on an attached statement.) Include the total on line 23 with your other miscellaneous deductions that are subject to the 2% limit.

For information on how to report amortizable bond premium, see Bond Premium Amortization, earlier in this chapter.

When To Report Investment Expenses

If you use the cash method to report income and expenses, you generally deduct your expenses, except for certain prepaid interest, in the year you pay them.

If you use an accrual method, you generally deduct your expenses when you incur a liability for them, rather than when you pay them.

Also see When To Deduct Investment Interest, earlier in this chapter.

Unpaid expenses owed to related party.   If you use an accrual method, you cannot deduct interest and other expenses owed to a related cash-basis person until payment is made and the amount is includible in the gross income of that person. The relationship, for purposes of this rule, is determined as of the end of the tax year for which the interest or expense would otherwise be deductible. If a deduction is denied under this rule, this rule will continue to apply even if your relationship with the person ceases to exist before the amount is includible in the gross income of that person.

This rule generally applies to those relationships listed in chapter 4 under Related Party Transactions. It also applies to accruals by partnerships to partners, partners to partnerships, shareholders to S corporations, and S corporations to shareholders.

The postponement of deductions for unpaid expenses and interest under the related party rule does not apply to original issue discount (OID), regardless of when payment is made. This rule also does not apply to loans with below-market interest rates or to certain payments for the use of property and services when the lender or recipient has to include payments periodically in income, even if a payment has not been made.

Illustrated Form 4952

Sales and Trades of Investment Property

Introduction

This chapter explains the tax treatment of sales and trades of investment property.

Investment property.   This is property that produces investment income. Examples include stocks, bonds, and Treasury bills and notes. Property used in a trade or business is not investment property.

Form 1099-B.   If you sold property such as stocks, bonds, or certain commodities through a broker during the year, you should receive, for each sale, a Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, or an equivalent statement from the broker. You should receive the statement by January 31 of the next year. It will show the gross proceeds from the sale. The IRS will also get a copy of Form 1099-B from the broker.

Use Form 1099-B (or an equivalent statement received from your broker) to complete Schedule D of Form 1040. For more information, see Form 1099-B transactions under Reporting Capital Gains and Losses, later.

Other property transactions.   Certain transfers of property are discussed in other IRS publications. These include:

• Sale of your main home, discussed in Publication 523, Selling Your Home,
• Installment sales, covered in Publication 537, Installment Sales,
• Various types of transactions involving business property, discussed in Publication 544, Sales and Other Dispositions of Assets,
• Transfers of property at death, covered in Publication 559, Survivors, Executors, and Administrators, and
• Disposition of an interest in a passive activity, discussed in Publication 925, Passive Activity and At-Risk Rules.

Topics

This chapter discusses:

• What a sale or trade is,
• Basis,
• Adjusted basis,
• Figuring gain or loss,
• Nontaxable trades,
• Capital gains and losses, and
• How to report your gain or loss.

Useful Items You may want to see:

Publication

• 551   Basis of Assets
• 564   Mutual Fund Distributions

Form (and Instructions)

• Schedule D (Form 1040)   Capital Gains and Losses
• 6781   Gains and Losses From Section 1256 Contracts and Straddles
• 8582   Passive Activity Loss Limitations
• 8824   Like-Kind Exchanges

See chapter 5 for information about getting these publications and forms.

What Is a Sale or Trade?

• Equity option
• Futures contract
• Marked to market
• Nonequity option
• Options dealer
• Regulated futures contract
• Section 1256 contract
• Short sale

This section explains what is a sale or trade. It also explains certain transactions and events that are treated as sales or trades.

A sale is generally a transfer of property for money or a mortgage, note, or other promise to pay money. A trade is a transfer of property for other property or services, and may be taxed in the same way as a sale.

Sale and purchase.   Ordinarily, a transaction is not a trade when you voluntarily sell property for cash and immediately buy similar property to replace it. The sale and purchase are two separate transactions. But see Like-Kind Exchanges under Nontaxable Trades, later.

Redemption of stock.   A redemption of stock is treated as a sale or trade and is subject to the capital gain or loss provisions unless the redemption is a dividend or other distribution on stock.

Dividend versus sale or trade.   Whether a redemption is treated as a sale, trade, dividend, or other distribution depends on the circumstances in each case. Both direct and indirect ownership of stock will be considered. The redemption is treated as a sale or trade of stock if:

1. The redemption is not essentially equivalent to a dividend - see Dividends and Other Corporate Distributions in chapter 1,
2. There is a substantially disproportionate redemption of stock,
3. There is a complete redemption of all the stock of the corporation owned by the shareholder, or
4. The redemption is a distribution in partial liquidation of a corporation.

Redemption or retirement of bonds.   A redemption or retirement of bonds or notes at their maturity generally is treated as a sale or trade. See Stocks, stock rights, and bonds and Discounted Debt Instruments under Capital or Ordinary Gain or Loss, later.

In addition, a significant modification of a bond is treated as a trade of the original bond for a new bond. For details, see section 1.1001-3 of the regulations.

Surrender of stock.   A surrender of stock by a dominant shareholder who retains control of the corporation is treated as a contribution to capital rather than as an immediate loss deductible from taxable income. The surrendering shareholder must reallocate his or her basis in the surrendered shares to the shares he or she retains.

Trade of investment property for an annuity.   The transfer of investment property to a corporation, trust, fund, foundation, or other organization, in exchange for a fixed annuity contract that will make guaranteed annual payments to you for life, is a taxable trade. If the present value of the annuity is more than your basis in the property traded, you have a taxable gain in the year of the trade. Figure the present value of the annuity according to factors used by commercial insurance companies issuing annuities.

Transfer by inheritance.   The transfer of property of a decedent to the executor or administrator of the estate, or to the heirs or beneficiaries, is not a sale or other disposition. No taxable gain or deductible loss results from the transfer.

Termination of certain rights and obligations.   The cancellation, lapse, expiration, or other termination of a right or obligation (other than a securities futures contract) with respect to property that is a capital asset (or that would be a capital asset if you acquired it) is treated as a sale. Any gain or loss is treated as a capital gain or loss.

This rule does not apply to the retirement of a debt instrument. See Redemption or retirement of bonds, earlier.

Worthless Securities

Stocks, stock rights, and bonds (other than those held for sale by a securities dealer) that became worthless during the tax year are treated as though they were sold on the last day of the tax year. This affects whether your capital loss is long-term or short-term. See Holding Period, later.

If you are a cash basis taxpayer and make payments on a negotiable promissory note that you issued for stock that became worthless, you can deduct these payments as losses in the years you actually make the payments. Do not deduct them in the year the stock became worthless.

How to report loss.   Report worthless securities on line 1 or line 8 of Schedule D (Form 1040), whichever applies. In columns (c) and (d), print Worthless. Enter the amount of your loss in parentheses in column (f).

Filing a claim for refund.   If you do not claim a loss for a worthless security on your original return for the year it becomes worthless, you can file a claim for a credit or refund due to the loss. You must use Form 1040X, Amended U.S. Individual Income Tax Return, to amend your return for the year the security became worthless. You must file it within 7 years from the date your original return for that year had to be filed, or 2 years from the date you paid the tax, whichever is later. (Claims not due to worthless securities or bad debts generally must be filed within 3 years from the date a return is filed, or 2 years from the date the tax is paid.) For more information about filing a claim, see Publication 556, Examination of Returns, Appeal Rights, and Claims for Refund.

Constructive Sales of Appreciated Financial Positions

You are treated as having made a constructive sale when you enter into certain transactions involving an appreciated financial position (defined later) in stock, a partnership interest, or certain debt instruments. You must recognize gain as if the position were disposed of at its fair market value on the date of the constructive sale. This gives you a new holding period for the position that begins on the date of the constructive sale. Then, when you close the transaction, you reduce your gain (or increase your loss) by the gain recognized on the constructive sale.

Constructive sale.   You are treated as having made a constructive sale of an appreciated financial position if you:

1. Enter into a short sale of the same or substantially identical property,
2. Enter into an offsetting notional principal contract relating to the same or substantially identical property,
3. Enter into a futures or forward contract to deliver the same or substantially identical property (including a forward contract that provides for cash settlement), or
4. Acquire the same or substantially identical property (if the appreciated financial position is a short sale, an offsetting notional principal contract, or a futures or forward contract).

You are also treated as having made a constructive sale of an appreciated financial position if a person related to you enters into a transaction described above with a view toward avoiding the constructive sale treatment. For this purpose, a related person is any related party described under Related Party Transactions, later in this chapter.

Exception for nonmarketable securities.   A contract for sale of any stock, debt instrument, or partnership interest that is not a marketable security is not a constructive sale if it settles within 1 year of the date you enter into it.

Exception for certain closed transactions.   Do not treat a transaction as a constructive sale if all of the following are true.

1. You closed the transaction before the end of the 30th day after the end of your tax year.
2. You held the appreciated financial position throughout the 60-day period beginning on the date you closed the transaction.
3. Your risk of loss was not reduced at any time during that 60-day period by holding certain other positions.

If a closed transaction is reestablished in a substantially similar position during the 60-day period beginning on the date the first transaction was closed, this exception still applies if the reestablished position is closed before the end of the 30th day after the end of your tax year in which the first transaction was closed and, after that closing, (2) and (3) above are true.

Appreciated financial position.   This is any interest in stock, a partnership interest, or a debt instrument (including a futures or forward contract, a short sale, or an option) if disposing of the interest would result in a gain.

Exceptions.   An appreciated financial position does not include the following.

1. Any position from which all of the appreciation is accounted for under marked to market rules, including section 1256 contracts (described later under Section 1256 Contracts Marked to Market).
2. Any position in a debt instrument if:
   1. The position unconditionally entitles the holder to receive a specified principal amount,
   2. The interest payments (or other similar amounts) with respect to the position are payable at a fixed rate or a variable rate described in section 1.860G-1(a)(3) of the regulations, and
   3. The position is not convertible, either directly or indirectly, into stock of the issuer (or any related person).
3. Any hedge with respect to a position described in (2).

Certain trust instruments treated as stock.   For the constructive sale rules, an interest in an actively traded trust is treated as stock unless substantially all of the value of the property held by the trust is debt that qualifies for the exception to the definition of an appreciated financial position (explained in (2) above).

Sale of appreciated financial position.   A transaction treated as a constructive sale of an appreciated financial position is not treated as a constructive sale of any other appreciated financial position, as long as you continue to hold the original position. However, if you hold another appreciated financial position and dispose of the original position before closing the transaction that resulted in the constructive sale, you are treated as if, at the same time, you constructively sold the other appreciated financial position.

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