Making tax-smart investment decisions
Not all income is created equal. The character of income determines its tax rate and treatment. Investment income alone comes in a variety of forms. Income such as dividends and interest arises from holding investments, while capital gains income results from the sale of investments.
Investment income is often treated more favorably than ordinary income, but the rules are complex. Long-term capital gains and qualifying dividends can be taxed as low as 15 percent, while nonqualified dividends, interest and short-term capital gains are taxed at ordinary income tax rates as high as 35 percent. Special rates also apply to specific types of capital gains and other investments, such as mutual funds and passive activities. But these rates aren’t scheduled to last forever. Unless Congress acts, rates will increase on all types of income in 2011. (See chart 4.)
The various rules and rates on investment income offer many opportunities for you to minimize your tax burden. Understanding the tax costs of various types of investment income can also help you make tax smart decisions. But remember that tax planning is just one part of investing. You must also consider your risk tolerance, desired asset allocation and whether an investment makes sense for your financial and personal situation.
Capital gains and losses
To benefit from long-term capital gains treatment, you must hold a capital asset for more than 12 months before it is sold. Selling an asset you’ve held for 12 months or less results in less favorable short-term capital gains treatment. Several specific types of assets have special, higher capital gains rates, and taxpayers in the bottom two tax brackets enjoy a zero rate on their capital gains and dividends in 2009 and 2010.
Your total capital gain or loss for tax purposes is generally calculated by netting all the capital gains and losses throughout the year. You can offset both short-term and long-term gains with either short-term or long-term losses. Taxpayers facing a large capital gains tax bill often find it beneficial to look for unrealized losses in their portfolio so they can sell the assets to offset their gains. But keep the wash sale rule in mind. You can’t use the loss if you buy the same — or a substantially identical — security within 30 days before or after you sell the security that creates the loss.
There are ways to mitigate the wash sale rule. You may be able to buy securities of a different company in the same industry or shares in a mutual fund that holds securities much like the ones you sold. Alternatively, consider a bond swap. (See Tax planning opportunity 5 on bond swaps.)
It may prove unwise to try and offset your capital gains at all. Up to $3,000 in net capital loss can be claimed against ordinary income (with a top rate of 35 percent in 2009 and 2010), and the rest can be carried forward to offset future short-term loss or ordinary income. More importantly, long-term capital gains rates in 2009 and 2010 are a low 15 percent, but are scheduled to increase to 20 percent in 2011. It may actually be time to consider selling assets with unrealized gains now to take advantage of the current low rates. (See Tax planning opportunity 6 for more on recognizing gains.)
Be careful, however. The 15-percent rate could be extended beyond 2010, at least to the extent the net capital gain does not push taxable income above $250,000 for a married couple filing a joint return. (Read more on the legislative prospects of tax increases.)
Regardless of whether you want to accelerate or mitigate a net capital gain, the tax consequences of a sale can come as a surprise, unless you remember the following rules:
- If you bought the same security at different times and prices, you should specifically identify in writing which shares are to be sold by the broker before the sale. Selling the shares with the highest basis will reduce your gain or increase your losses.
- For tax purposes, the trade date and not the settlement date of publicly traded securities determines the year in which you recognize the gain or loss.
Use zero capital gains rate to benefit children
Taxpayers in the bottom two tax brackets pay no taxes on long-term capital gains and qualifying dividends in 2009 and 2010. If income from these items would be in the 10-percent or 15-percent bracket based on a taxpayer’s income, than the tax rate is zero.
If you have adult children in these tax brackets, consider giving them dividend-producing stock or long-term appreciated stock. They can sell the stock for gains or hold the stock for dividends without owing any taxes.
Keep in mind there could be gift tax and estate planning consequences. (Learn about gifting strategies.) Gifts to children up to the age of 23 can also be subject to the “kiddie tax.” (Read more on the kiddie tax.)
Mutual fund pitfalls
Investing in mutual funds is an easy way to diversify your portfolio, but comes with tax pitfalls. Earnings on mutual funds are typically reinvested. Unless you (or your broker or investment advisor) keep track of these additions to your basis, and you designate which shares you are selling, you may report more gain than required when you sell the fund.
It is often a good idea to avoid buying shares in an equity mutual fund right before it declares a large capital gains distribution, typically at year-end. If you own the shares on the record date of the distribution, you’ll be taxed on the full distribution amount even though it may include significant gains realized by the fund before you owned the shares. Worse yet, you’ll end up paying taxes on those gains in the current year — even if you reinvest the distribution in the fund and regardless of whether your position in the fund has appreciated.
Small business stock comes with tax rewards
Buying stock in a qualified small business (QSB) comes with several tax benefits, assuming you comply with specific requirements and limitations. If you sell QSB stock at a loss, you can treat up to $50,000 ($100,000, if married filing jointly) as an ordinary loss, regardless of your holding period. This means you can use it to offset ordinary income taxed at a 35-percent rate, such as salary and interest.
You can also roll over QSB stock without realizing gain. If you buy QSB stock with the proceeds of a sale of QSB stock within 60 days, you can defer the tax on your gain until you dispose of the new stock. The new stock’s holding period for long-term capital gains treatment includes the holding period of the stock you sold.
Most importantly, you may only have to pay an effective rate as low as seven percent on long-term gain of QSB stock. The gain is normally taxed at a 28-percent rate, but a 50-percent exclusion allows for an effective tax rate of 14 percent. However, the stimulus bill enacted in February 2009 allows taxpayers to exclude 75 percent of the gain from qualifying stock bought after Feb. 17, 2009, and before Jan. 1, 2011, for an effective tax rate of just seven percent.
Rethinking dividend tax treatment
The tax treatment of income-producing assets can affect investment strategy. Qualifying dividends generally are taxed at the reduced rate of 15 percent, while interest income is taxed at ordinary-income rates of up to 35 percent. So, dividend-paying stocks may be more attractive from a tax perspective than investments like CDs and bonds. But there are exceptions.
Some dividends are subject to ordinary-income rates. These may include certain dividends from:
- money market mutual funds,
- mutual savings banks,
- real estate investment trusts (REITs),
- foreign investments,
- regulated investment companies, and
- stocks, to the extent the dividends are offset by margin debt.
Some bond interest is exempt from income tax. Interest on U.S. government bonds is taxable on your federal return, but it’s generally exempt on your state and local returns. Interest on state and local government bonds is excludible on your federal return. If the state or local bonds were issued in your home state, interest also may be excludible on your state return. Although state and municipal bonds usually pay a lower interest rate, their rate of return may be higher than the after-tax rate of return for a taxable investment.
Review portfolio for tax balance
You should consider which investments to hold inside and outside your retirement accounts. If you hold taxable bonds to generate income and diversify your overall portfolio, consider holding them in a retirement account where there won’t be a current tax cost.
Bonds with original issue discount (OID) build up “interest” as they rise toward maturity. You’re generally considered to earn a portion of that interest annually — even though the bonds don’t pay you this interest annually — and you must pay tax on it. They also may be best suited for retirement accounts. Try to own dividend-paying stocks that qualify for the 15-percent tax rate outside of retirement plans so you’ll benefit from the lower rate.
It’s also important to reallocate your retirement plan assets periodically. For example, the allocation you set up for your 401(k) plan 10 years ago may not be appropriate now that you’re closer to retirement. (Read more on saving for retirement.)
Planning for passive losses
There are special rules for income and losses from a passive activity. Investments in a trade or business in which you don’t materially participate are passive activities. You can prove your material participation by participating in the trade or business for more than 500 hours during the year or by demonstrating that your involvement represents substantially all of the participation in the activity.
The designation of a passive activity is important, because passive activity losses are generally deductible only against income from other passive activities. You can carry forward disallowed losses to the following year, subject to the same limitations. There are options for turning passive losses into tax-saving opportunities.
You can increase your activity to more than 500 hours. Alternatively, you can limit your activities in another business to less than 500 hours or invest in another income-producing business that will be passive to you. Either way, the other businesses can give passive income to offset your passive losses. Finally, consider disposing of the activity to deduct all the losses. The disposition rules can be complex, so consult with a Grant Thornton tax advisor.
Rental activity has its own set of passive loss rules. Losses from real estate activities are passive by definition unless you’re a real estate professional. If you’re a real estate professional, you can deduct real estate losses in full, but you must perform more than half of your personal services in real property trades and businesses annually and spend more than 750 hours in these services during the year.
If you actively participate in a rental real estate activity but you aren’t a real estate professional, you may be able to deduct up to $25,000 of real estate losses each year. This deduction is subject to a phaseout beginning when adjusted gross income (AGI) reaches $100,000 ($50,000 for married taxpayers filing separately).
Leveraging investment expenses
You are allowed to deduct expenses used to generate investment income unless they are related to tax-exempt income. Investment expenses can include investment firm fees, research costs, security costs such as a safe deposit box, and most significantly, investment interest. Apart from investment interest, these expenses are considered miscellaneous itemized deductions and are deductible only to the extent they exceed two percent of your AGI.
Investment interest is interest on debt used to buy assets held for investment, such as margin debt used to buy securities. Payments a short seller makes to the stock lender in lieu of dividends may be deductible as an investment interest expense. Your investment interest deduction is limited to your net investment income, which generally includes taxable interest, dividends and short-term capital gains. Any disallowed interest is carried forward for a deduction in a later year, which may provide a beneficial opportunity. (See Tax planning opportunity 7.)
If you don’t want to carry forward investment interest expense, you can elect to treat net long-term capital gain or qualified dividends as investment income in order to deduct more of your investment interest, but it will be taxed at ordinary-income rates. Remember that interest on debt used to buy securities that pay tax-exempt income, such as municipal bonds, isn’t deductible. Also keep in mind that passive interest expense — interest on debt incurred to fund passive activity expenditures — becomes part of your overall passive activity income or loss, subject to limitations.
Be wary of deferral strategies
Deferring taxes is normally a large part of good planning. But with capital gains rates scheduled to go up, the benefits of deferring income may be outweighed by the burden of higher tax rates in the future. If you believe your rates will go up, consider avoiding or fine tuning strategies to defer gain, such as an installment sale or like-kind exchange.
Like-kind exchanges under Section 1031 allow you to exchange real estate without incurring capital gains tax. Under a like-kind exchange, you defer paying tax on the gain until you sell your replacement property. An installment sale allows you to defer capital gains on most assets other than publicly traded securities by spreading gain over several years as you receive the proceeds. If you’re engaging in an installment sale, consider creating a future exit strategy. You may want to build in the ability to pledge the installment obligation. Deferred income on most installment sales made after 1987 can be accelerated by pledging the installment note for a loan. The proceeds of the loan are treated as a payment on the installment note itself. If legislation is enacted that increases the capital gains rate in the future (or makes clear the scheduled increase will occur), this technique can essentially accelerate the proceeds of the installment sale.
Your home as an investment
There are many home-related tax breaks. Whether you own one home or several, it’s important to take advantage of your deductions and plan for any gains or rental income.
Property tax is generally deductible as an itemized deduction. Even if you don’t itemize, a provision scheduled to expire in 2010 allows you an above-the-line deduction of up to $500 ($1,000 if filing jointly) on personal property taxes. But remember, property tax isn’t deductible for alternative minimum tax (AMT) purposes.
You can also deduct mortgage interest and points on your principal residence and a second home. The deduction is good for interest on up to $1 million in total mortgage debt used to purchase, build or improve your homes. In addition, you can deduct interest on a home equity loan with a balance up to $100,000. Consumer interest isn’t deductible, so consider using home equity debt (up to the $100,000 limit) to pay off credit cards or auto loans. But remember, home equity debt is not deductible for the AMT unless it’s used for home improvements.
When you sell your home, you can generally exclude up to $250,000 ($500,000 for joint filers) of gain if you’ve used it as your principal residence for two of the preceding five years. But under a recently enacted provision, you will have to include gain on a pro-rata basis for any years after 2009 that the home was not used as your principal residence. Maintain thorough records to support an accurate tax basis, and remember, you can only deduct losses attributable exclusively for business or rental use (subject to various limitations).
The rules for rental income are complicated, but you can rent out all or a portion of your primary residence and second home for up to 14 days without having to report the income. No rental expenses will be deductible. If you rent out your property for 15 days or more, you have to report the income, but can also claim all or a portion of your rental expenses — such as utilities, repairs, insurance and depreciation. Any deductible expenses in excess of rental income can be carried forward.
If the home is classified as a rental for tax purposes, you can deduct interest that’s attributable to its business use but not any interest attributable to personal use.
