Taxation

Tax Deductible versus Capitalized Securities Expenses

Individuals who buy and sell securities must report costs that relate to their investment activities on their tax returns. Some costs are treated as ordinary and necessary expenses that may be deducted from income. Other costs must be treated as capital expenditures that aren't deductible but can be used for depreciation or amortization.

Depreciation is the decline in an asset's value. Amortization is when you gradually eliminate a debt by paying part of the principal (debt or investment minus the interest) each time you make an interest payment.

Capitalized Expenses

Commissions paid by individual investors on the acquisition of securities must be added to the cost of the securities. This is true even for purchases made by dealers in securities as well as purchases by a corporation. Purchase commissions may not be deducted even though they're a regular and recurring expense of buying and selling securities. Also, litigation expenses incurred in appraisal proceedings for the purchase of minority shares are generally nondeductible and are treated as part of the stock's acquisition cost.

An investor or trader (even one whose activities can be characterized as a trade or business) must use commissions, as well as most other selling expenses, as an offset against the selling price to reduce the amount of gain or increase the amount of loss realized from the transaction. Sales of securities result in capital gains and losses that must be reported on Form 1040, Schedule D, Capital Gains and Losses.

Deductible Expenses

Investors can generally deduct the expenses of producing taxable investment income, including expenses for investment counseling and advice, legal and accounting fees and investment newsletters. These expenses are deductible on Form 1040, Schedule A, Itemized Deductions, as miscellaneous deductions. Deductions are allowed only to the extent that they exceed 2% of adjusted gross income. Interest paid on money to buy or carry investment property that produces taxable income is also deductible on Schedule A. This deduction can't exceed the net investment income.

Determining Deduction versus Capitalization Using Origin Test

The origin test should be applied whenever you're uncertain about whether an expense incurred for the purchase of securities is deductible or must be capitalized. The test involves making a determination about whether the expense originated in the process of acquiring the securities. If the expense originated in the acquisition process itself, then it must be capitalized. For example, purchase commissions are considered capital items, even if not governed by a particular provision of the regulations, since the taxpayer would not have incurred the expense but for the purchase of the securities.

Sometimes it's difficult to determine whether an expense was incurred in the acquisition process. For example, if the expenditures relate to a lawsuit against a corporate executive or broker-dealer, the crucial factor is the ground upon which the suit is based. If it's against the executive as a purchaser of stock, or against the broker-dealer on a claim that arose in the investment process, the expenditure won't be deductible.

Questions for Your Attorney

  • What expenses related to purchasing and selling securities may be deducted?
  • What expenses related to purchasing and selling securities must be capitalized?
  • What should I do if I am uncertain about whether an expense related to securities is deductible?
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