Tax planning for investments can get complicated
Tax treatment of investments can vary dramatically based on several factors — including type of investment, type of income it produces, how long it’s been held, whether any special limitations or breaks apply and potentially changing tax rates and rules. Consequently, tax planning for investments is always complicated. So, although tax considerations shouldn’t be the primary driver of investment decisions, make sure you consider the potential tax consequences of your decisions under multiple scenarios.
Capital gains tax and timing
While time, not timing, is generally the key to long-term investment success, timing can have a dramatic impact on the tax consequences of investment activities. The 15% long-term capital gains rate is 20 percentage points lower than the highest ordinary-income rate of 35%. It generally applies to investments held for more than 12 months. (Higher long-term gains rates apply to certain types of assets — see the Chart “What’s the maximum capital gains tax rate?”)
Holding on to an investment until you’ve owned it more than a year may help substantially cut tax on any gain. But without Congressional action, in 2013 the 15% long-term capital gains rate will rise to 20%. So there may be actions you’ll want to take now to lock in lower rates while they’re still available.
To determine capital gains tax liability, realized capital gains are netted against realized capital losses. First, short-term gains are netted with short-term losses and long-term gains with long-term losses. Then if, for example, you have a net short-term gain but a net long-term loss, you can use the long-term loss to offset the short-term gain. This can save more taxes because you’re reducing or eliminating gain that would have been taxed at your higher ordinary-income rate.
 Remember that appreciating investments that don’t generate current income aren’t taxed until sold, deferring tax and perhaps allowing you to time the sale to your tax advantage — such as in a year when you have capital losses to absorb the capital gain.
If you’ve cashed in some big gains during the year and want to reduce your tax liability, before year end look for unrealized losses in your portfolio and consider selling them to offset your gains.
The wash sale rule
If you’re trying to achieve a tax loss with minimal change in your portfolio’s asset allocation, keep in mind the wash sale rule. It prevents you from taking a loss on a security if you buy a substantially identical security (or option to buy such a security) within 30 days before or after you sell the security that created the loss. You can recognize the loss only when you sell the replacement security.
Fortunately, there are ways to avoid the wash sale rule. For example, you may immediately 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. Or, you can wait 31 days to repurchase the same security. Alternatively, before selling the security, you can purchase additional shares of that security equal to the number you want to sell at a loss, and then wait 31 days to sell the original portion.
You also can do a bond swap, where you sell a bond, take a loss and then immediately buy another bond of similar quality and duration from a different issuer. Generally, the wash sale rule doesn’t apply because the bonds aren’t considered substantially identical. Thus, you achieve a tax loss with virtually no change in economic position.
Loss carryovers
If net losses exceed net gains, you can deduct only $3,000 ($1,500 for married taxpayers filing separately) of the net losses per year against ordinary income. You can carry forward excess losses to future years indefinitely.
By determining whether, year to date, you have excess losses, you can time sales of other investments before year end to achieve your tax planning goals. For example, loss carryovers can be a powerful tax-saving tool in future years if you have a large investment portfolio, real estate holdings or a closely held business that might generate substantial future capital gains. They’ll be even more powerful if rates go up in 2013.
If, on the other hand, it looks like it could take a long time to fully absorb a large loss carryover, you might want to realize gains before year end to absorb excess losses — as long as this will also help you accomplish your investment goals. Remember that capital gains distributions from mutual funds can also absorb capital losses.
If you don’t have enough gains to absorb more losses and you want to minimize loss carryovers, from a tax perspective it might not make sense to sell any more investments at a loss. Plus, if you hold on to an investment, it may recover its lost value. But if you’re ready to divest yourself of a poorly performing stock because you think it will continue to lose value — or because your investment objective or risk tolerance has changed — don’t hesitate solely for tax reasons.
Paying attention to details
If you don’t pay attention to the details, the tax consequences of a sale may be different from what you expect. For example, the trade date, not the settlement date, of publicly traded securities determines the year in which you recognize the gain or loss.
And if you bought the same security at different times and prices, and you want to sell high-tax-basis shares to reduce gain or increase a loss and offset other gains, be sure to specifically identify which block of shares is being sold.
The 0% rate
Through 2012, the long-term capital gains rate is 0% for gain that would be taxed at 10% or 15% based on the taxpayer’s ordinary-income rate. If you have adult children in one of these tax brackets, consider transferring appreciated or dividend-producing assets to them so they can enjoy the 0% rate, which also applies to qualified dividends. (See the Case Study “Just because you don’t qualify doesn’t mean you can’t benefit from the 0% rate.”)
Warning: If the child is under age 24, first make sure he or she won’t be subject to the “kiddie” tax. (See “The ‘kiddie tax’.”) Also, consider any gift tax consequences. (See “Gift tax.”)
Mutual funds
Investing in mutual funds is an easy way to diversify your portfolio. But beware of the tax pitfalls. First, mutual funds with high turnover rates can create income taxed at ordinary-income rates. Choosing funds that provide primarily long-term gains can save you more tax dollars because of the lower long-term rates.
Second, earnings on mutual funds are typically reinvested, and unless you (or your investment advisor) keep track of these additions — and increase your basis accordingly — you may report more gain than required when you sell the fund.
Third, buying equity mutual fund shares later in the year can be costly tax-wise. Such funds often declare a large capital gains distribution at year end. If you own the shares on the distribution’s record date, you’ll be taxed on the full distribution amount even if it includes significant gains realized by the fund before you owned the shares. And you’ll pay tax on those gains in the current year — even if you reinvest the distribution. (See the Case Study “Mutual fund distributions can cost you taxes.”)
Small business stock
By purchasing stock in certain small businesses, you can diversify your portfolio. You also may enjoy preferential tax treatment:
Conversion of capital loss to ordinary loss. If you sell qualifying Section 1244 small business stock at a loss, you can treat up to $50,000 ($100,000, if married filing jointly) as an ordinary, rather than a capital, loss — regardless of your holding period. This means you can use it to offset ordinary income, reducing your tax by as much as 35% on this portion of the loss. Sec. 1244 applies only if total capital invested isn’t more than $1 million.
Tax-free gain rollovers. If within 60 days of selling qualified small business (QSB) stock you buy other QSB stock with the proceeds, you can defer the tax on your gain until you dispose of the new stock. The rolled-over gain reduces your basis in the new stock. For determining long-term capital gains treatment, the new stock’s holding period includes the holding period of the stock you sold.
To be a QSB, a business must be engaged in an active trade or business and must not have assets that exceed $50 million.
Exclusion of gain. Generally, taxpayers selling QSB stock are allowed to exclude up to 50% of their gain as long as they’ve held the stock for at least five years. But, depending on the acquisition date, the exclusion may be greater. (See “What’s new! 100% gain exclusion for certain small business stock purchased by Dec. 31, 2011.”)
The taxable portion of any QSB gain will be subject to the lesser of your ordinary-income rate or 28%, rather than the normal long-term gains rate. (See the Chart “What’s the maximum capital gains tax rate?”) Thus, if the 28% rate and the 50% exclusion apply, the effective rate on the QSB gain will be 14% (28% × 50%).
Keep in mind that all three of these tax benefits are subject to specific requirements and limits. Consult your tax or financial advisor to be sure an investment in small business stock is right for you.
Passive losses
If you’ve invested in a trade or business in which you don’t materially participate, remember that passive activity losses generally are deductible only against income from other passive activities. You can carry forward disallowed losses to the following year, subject to the same limits.
To avoid passive activity treatment, typically you must participate in a trade or business more than 500 hours during the year or demonstrate that your involvement constitutes substantially all of the participation in the activity. (Special rules apply to real estate; see “Real estate activity losses.”) If you don’t pass this test, consider:
Increasing your involvement. If you can exceed 500 hours, the activity no longer will be subject to passive loss limits. If the business is structured as a limited liability company (LLC), possible changes in IRS regulations may reduce the number of hours you must be involved. Check with your tax advisor for more information.
Disposing of the activity. You’re then allowed to deduct all the losses — including any loss on disposition (subject to basis and capital loss limitations). But the rules are complex, so consult your tax advisor.
Looking at other activities. Limit your participation in another activity that’s generating income, so that you don’t meet the 500 hours test, or invest in another income-producing trade or business that will be passive to you. Under both strategies, you’ll then have passive income that can absorb your passive losses.
Income investments
While qualified dividends generally are taxed at the reduced rate of 15%, interest income generally is taxed at ordinary-income rates up to a maximum of 35%. So, dividend-paying stocks may be more attractive from a tax perspective than other income investments, such as CDs and bonds. Warning: Without Congressional action, you have only through 2012 to take advantage of the 15% rate.
But some income investments receive different tax treatment.
First, some dividends are subject to ordinary-income rates. These may include certain dividends from:
- Real estate investment trusts (REITs),
- Regulated investment companies (RICs),
- Money market mutual funds, and
- Certain foreign investments.
Second, the tax treatment of bond income varies. For example:
- Interest on U.S. government bonds is taxable on federal returns but generally exempt on state and local returns.
- Interest on state and local government bonds is excludible on federal returns. If the bonds were issued in your home state, interest also may be excludible on your state return.
- Corporate bond interest is fully taxable for federal and state purposes.
- Bonds (except U.S. savings 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 this interest annually — and you must pay tax on it.
Keep in mind that, 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, depending on your tax rate. (See the Case Study “Comparing tax-exempt and taxable bond yields.”)
Investment interest expense
Investment interest — interest on debt used to buy assets held for investment, such as margin debt used to buy securities — is deductible. But special rules apply.
Your investment interest deduction is limited to your net investment income, which generally includes taxable interest, nonqualified dividends and net short-term capital gains (but not long-term capital gains), reduced by other investment expenses. Any disallowed interest is carried forward, and you can deduct it in a later year if you have excess net investment income.
You may elect to treat net long-term capital gain or qualified dividends as investment income in order to deduct more of your investment interest. But if you do, that portion of the long-term capital gain or dividend is taxed at ordinary-income rates.
Payments a short seller makes to the stock lender in lieu of dividends may be deductible as an investment interest expense. But 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. •
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