Are K-1 Portfolio Deductions Deductible?
Understand the tax implications of K-1 portfolio deductions. Current rules create different outcomes for investment expenses and interest on your return.
Receiving a Schedule K-1 means you are an owner or beneficiary of a pass-through entity, such as a partnership, S corporation, or trust. These entities do not pay income tax themselves; instead, they pass their income, credits, and deductions to their owners to report on their personal tax returns. Among the items passed through are portfolio deductions, which are expenses the entity incurred related to its investment activities. Understanding whether you can use these deductions requires navigating a specific set of tax rules.
Identifying Portfolio Deductions on a K-1
To determine if you have portfolio deductions, you must examine the Schedule K-1 you received. For investors in a partnership, this information is in Box 13 of Form 1065 Schedule K-1. For shareholders in an S corporation, the equivalent information is in Box 12 of Form 1120-S Schedule K-1.
On both forms, Code H is used for “Investment interest expense.” Other portfolio deductions, such as investment advisory fees and management costs, are often reported with Code AE. Code L reports other portfolio-related deductions that are not subject to the same suspension rules.
The amounts shown represent your pro-rata share of the entity’s total expenses. For instance, if you own 10% of a partnership that incurred $5,000 in investment advisory fees, your K-1 would show $500 of these deductions. These are not your personal expenses but rather the entity’s expenses being allocated to you.
Understanding Key Deduction Limitations
The ability to deduct portfolio expenses from your K-1 is governed by limitations that were altered by the Tax Cuts and Jobs Act of 2017 (TCJA). The rules differ based on the type of deduction, so each must be analyzed separately to determine its treatment on your personal tax return.
Other Investment Expenses
Most deductions reported as “other portfolio deductions,” such as investment advisory and management fees, fall under the classification of miscellaneous itemized deductions. The TCJA suspended the deduction for all miscellaneous itemized deductions for tax years 2018 through 2025.
As a result, for federal income tax purposes, these “other portfolio deductions” from a K-1 are not deductible on your Schedule A (Itemized Deductions). This means that even though the partnership or S corporation incurred these expenses and allocated them to you, you receive no direct tax benefit from them on your individual income tax return during this suspension period.
Investment Interest Expense
Investment interest expense, reported under Code H on the K-1, is treated differently and was not suspended by the TCJA. This expense, which is interest paid on money borrowed to purchase investments, remains potentially deductible. The primary limitation is that the deduction cannot exceed your net investment income for the year.
Net investment income is the total of your investment-related income minus any other deductible investment expenses. Investment income includes interest, non-qualified dividends, and royalties. This rule prevents taxpayers from using investment interest to offset other types of income, such as wages, ensuring the deduction is tied to the investment income it helped generate.
How to Report K-1 Portfolio Deductions
Correctly reporting any allowable deductions on your tax return is the next step. The process is distinct for investment interest expense versus other portfolio expenses, as one requires a specific form while the other may affect a separate tax calculation.
Reporting Investment Interest Expense
To deduct investment interest expense from your K-1, you must complete Form 4952, “Investment Interest Expense Deduction.” The amount from your K-1 is entered on this form, where you will combine it with any other investment interest you personally paid. On the same form, you calculate your total net investment income, which serves as the ceiling for your deduction.
The final calculated amount from Form 4952 is your allowable investment interest deduction for the year. This figure is then carried to Schedule A (Itemized Deductions). If your total investment interest expense exceeds your net investment income, the excess amount is carried forward to the following tax year, where it can be deducted subject to that year’s net investment income limitation.
Reporting Other Investment Expenses
While other portfolio investment expenses are not deductible on Schedule A for regular tax purposes, they may provide a tax benefit when calculating the Net Investment Income Tax (NIIT). The NIIT is a 3.8% tax on the lesser of your net investment income or the amount your modified adjusted gross income exceeds certain thresholds.
When calculating your net investment income for the NIIT on Form 8960, you are allowed to deduct investment expenses directly connected to producing investment income. This is where the “other portfolio deductions” from your K-1 can be used. They can reduce the amount of income subject to the 3.8% NIIT, providing a different form of tax relief.