|
|
Tax planning for investments gets even more complicated this year 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, while tax consequences should never drive investment decisions, it’s critical that they be considered before making any moves. Although the American Taxpayer Relief Act of 2012 (ATRA) made 2012 tax rates on investments for most taxpayers permanent, higher-income taxpayers may face more taxes on their investment income in the form of the returning 20% top long-term capital gains rate and the new 3.8% Medicare tax - kicking in at different income levels based on different definitions of income. Capital gains tax and timing Although 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. A taxpayer’s long-term capital gains rate can be as much as 20 percentage point lower than his or her ordinary-income tax rate. The long-term gains rate generally is 15% and applies to investments held for more than 12 months. (Higher long-term gains rates apply to higher-income taxpayers and to certain types of assets. Holding on to an investment until you’ve owned it more than a year may help substantially cut tax on any gain — even if higher long-term gains rates apply. Also, 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. To determine capital gains tax liability, realized capital gains are netted against any realized capital losses. If you’ve already 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 triggering the wash sale rule and still achieve your goals. For example, you can:
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 won’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. But if you don’t expect substantial future gains, it could take a long time to fully absorb a large loss carryover. So, from a tax perspective, you may not want to sell any more investments at a loss if you won’t have enough gains to absorb most of it. (Remember, however, that capital gains distributions from mutual funds can also absorb capital losses.) Plus, if you hold on to an investment, it may recover its lost value. Nevertheless, 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 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 ATRA made permanent the 0% rate for long-term 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. Warning: If the child will be under age 24 on Dec. 31, first make sure he or she won’t be subject to the “kiddie” tax. Also consider any gift tax consequences. 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. Since 2012, brokerage firms have been required to track (and report to the IRS) your cost basis in mutual funds acquired during the tax year. 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. 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% of 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: The exclusion is 75% for stock acquired after Feb. 17, 2009, and before Sept. 28, 2010, and 100% for stock acquired after Sept. 27, 2010, and before Jan. 1, 2014. (The latter acquisition deadline had been Dec. 31, 2011, but ATRA retroactively extended it. This can be a powerful tax-saving tool, especially for higher-income taxpayers. 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 and financial advisors to be sure an investment in small business stock is right for you. Passive activities If you’ve invested in a trade or business in which you don’t materially participate, remember the passive activity rules. Why? Passive activity income may be subject to the 3.8% Medicare contribution tax on net investment income, and 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; 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 activity rules. If the business is structured as a limited liability company (LLC), proposed IRS regulations may make it easier for you to meet the material participation requirement. Check with your tax advisor for more information. Grouping activities. You may be able to group certain activities together to be treated as one activity for tax purposes and exceed the 500-hour threshold. But the rules are complex, and there are potential downsides to consider. Disposing of the activity. This generally allows you to deduct all the losses — including any loss on disposition (subject to basis and capital loss limitations). But, again, the rules are complex. Looking at other activities. Another option if you have passive losses is to 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 have passive income that can absorb your passive losses. Income investments ATRA makes long-term capital gains tax treatment of qualified dividends permanent. So the tax rate on such dividends generally will be 15% (or 0% for taxpayers in the 10% or 15% ordinary-income tax bracket). But higher-income taxpayers may face a tax increase, because under ATRA a 20% long-term capital gains rate generally applies if 2014 taxable income exceeds $406,750 (singles), $432,200 (heads of households) or $457,600 (married couples filing jointly). However, this is still a lower rate than these taxpayers would have paid if dividends had returned to being taxed at ordinary-income rates, as had been scheduled for 2013. Interest income continues to generally be taxed at ordinary-income rates, which are now as high as 39.6%. So stocks that pay qualified dividends currently may be more attractive tax-wise than other income investments, such as CDs, money market accounts and bonds. But there are exceptions. Some dividends are subject to ordinary-income rates. These may include certain dividends from:
Warning: A new Medicare tax also may apply to your dividend and interest income. The tax treatment of bond income varies. For example:
Tax-equivalent yield = actual yield / (1 - your marginal tax rate) 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 for both regular tax and AMT purposes. 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 gains 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. |
