ExpertMedium1 markMultiple Choice
CPA · Question 04 · Area 1: Individual Tax
A taxpayer has $10,000 of investment interest expense in Year 1. They have the following income items:<br/>- Salary: $150,000<br/>- Interest Income: $2,000<br/>- Non-qualified Dividends: $1,000<br/>- Qualified Dividends: $3,000<br/>- Long-term Capital Gains: $4,000<br/><br/>The taxpayer wants to minimize their tax liability for Year 1 and future years combined. They do NOT make any special elections regarding the taxation of capital gains or qualified dividends. What is the maximum investment interest expense deduction allowed in Year 1?
A taxpayer has $10,000 of investment interest expense in Year 1. They have the following income items:<br/>- Salary: $150,000<br/>- Interest Income: $2,000<br/>- Non-qualified Dividends: $1,000<br/>- Qualified Dividends: $3,000<br/>- Long-term Capital Gains: $4,000<br/><br/>The taxpayer wants to minimize their tax liability for Year 1 and future years combined. They do NOT make any special elections regarding the taxation of capital gains or qualified dividends. What is the maximum investment interest expense deduction allowed in Year 1?
Answer options:
A.
$3,000
B.
$6,000
C.
$10,000
D.
$7,000
How to approach this question
1. Identify Investment Interest Expense: $10,000.<br/>2. Calculate Net Investment Income (NII).<br/>3. Standard NII includes: Interest, Non-qualified dividends, Short-term capital gains, Royalties.<br/>4. Excluded (unless election made): Qualified Dividends, Long-term Capital Gains.<br/>5. Calculate NII: $2,000 (Interest) + $1,000 (Non-qual Div) = $3,000.<br/>6. Deduction limited to NII.
Full Answer
A.$3,000✓ Correct
Investment interest expense is limited to Net Investment Income. By default, NII includes interest, annuities, royalties, and short-term gains. It excludes Qualified Dividends and Long-Term Capital Gains unless the taxpayer elects to forego the preferential tax rates on those items. The question states no special elections were made. Therefore, NII = $2,000 (Interest) + $1,000 (Non-qualified Dividends) = $3,000. The deduction is limited to $3,000. The remaining $7,000 is carried forward.
Common mistakes
Including qualified dividends or LTCG in the NII calculation without noting the requirement to elect ordinary tax treatment.
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