The new Jobs and Growth Tax Relief Reconciliation Act or 2003 has turned the world of taxes on its head. With the new lower tax rates on dividends and long-term capital gains, many investors are trying to find ways to generate deductions that will reduce taxable ordinary income while benefiting from the much lower taxes on investments.
One such strategy is to borrow money in order to purchase dividend-paying stocks. It works like this: The interest on the borrowed funds will be deductible at your ordinary tax rate (up to 35% for the highest bracket taxpayers), while the dividends you receive will be taxed at a preferred tax rate of 15%. And if the stock increases in value and is sold more than a year after the purchase, the long-term gain will also be subject to a preferred tax rate of 15%. So that's quite a tax coup if you can make it work.
It appears that many folks do believe it will work. I've received a number of calls from clients telling me that their brokers or financial advisors are urging them to undertake this little gambit. I've also seen this ploy discussed on the Internet and in print.
But I'm afraid that many of those folks who undertake this strategy will be sorely disappointed when tax time rolls around. For many people, it just won't work.
First, remember that interest isn't automatically deductible any longer, and it hasn't been for quite some time (think about your credit card interest). For interest to be deductible, it must fall into one of a few special categories and often meet certain requirements. When you borrow money to purchase stock (either via your margin account or from another source), the interest that you pay is investment interest.
Investment interest is a very specialized type of interest expense. It's so specialized, it can only be deducted if you have net investment income. If you have more investment interest expense than you have net investment income, that excess expense is required to be carried forward to the following year and is subject to the same net investment interest limitations all over again.
Under the old rules dealing with net investment income, dividend income was included as net investment income (along with interest, short-term gains, and certain royalties). But no longer. When the new law granting a preferred 15% tax rate to qualifying dividends went into effect, it also removed income from qualified dividends from the definition of net investment income.
So, if your only income from this tax ploy is the dividend income from the shares that you purchased with the borrowed funds, you don't have net investment income. That being the case, you will not be able to deduct the interest expense on the funds borrowed to purchase the dividend-paying stock.
You can make an election to include dividend income as a component of net investment income. But if you do so, you also forfeit the preferred 15% tax rate on those qualified dividends. So in effect, you would simply be offsetting both the income and interest deduction at ordinary rates.
If you have sufficient other net investment income -- such as substantial interest income or short-term gains -- you can make this work. You would be allowed the preferred 15% rate on your dividend income, and your other net investment income would be used to offset your investment interest expense. Sweet.
Another way to secure the interest-expense deduction at your ordinary rates while benefiting from the lower tax rates on dividends is through a home-equity loan. The interest that you pay on a qualified home-equity loan will be treated as home-equity loan interest, and won't be subject to the investment interest rules.
But is that something that you really want to do? Potentially jeopardize your home in order to purchase stocks? I'm not so sure. But it would work, at least from a tax standpoint.
One other thought while we're talking dividends. Many folks believe that all dividends qualify for the lower tax treatment. That's not the case. A few of you are buying shares of stock immediately before the ex-dividend date (the day following the last day on which shareholders of record are entitled to receive the upcoming dividend payment), and then immediately turning around and selling the shares the very next day.
Since the price of a stock is reduced by the amount of the dividend on the ex-dividend date, this creates a capital loss. The thinking goes, the loss that will be generated on the sale of the shares will reduce income at ordinary tax rates while the dividends will be taxed a much lower 15% rate. But not in this case.
For dividends to qualify for the 15% tax rate, the stock must be held for more than 60 days during the 120-day period that begins 60 days before the ex-dividend date. So buying a stock that's ready to go ex-dividend won't necessarily render the desired result, especially if the shares are sold prior to meeting the 61-day holding period.
Be careful when you hear or read about something that sounds too good to be true. And always remember: In some cases, the best way to double your money is to fold it in half and stick it back in your pocket.
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Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.