Zero Capital Gains Rate Requires Careful Planning

One of the greatest benefits of the tax code is the special tax rates that currently apply to gain recognized from the sale of capital assets held for more than a year (long-term).  The special tax rates apply to virtually all capital assets including stock, land, improved real estate, your home, and business assets in excess of the accumulated depreciation previously deducted. These special rates, which apply to net long-term capital gains (LTCG)* and qualified dividends are zero percent to the extent that your regular tax rate is 15% or less, 15% to the extent your regular tax rate is 25% through 35% and 20% for all other long-term capital gains.  These rates, which apply only to non-corporate taxpayers, also apply for the alternative minimum tax.

This zero tax rate provides an extraordinary opportunity for a taxpayer to cash in on certain gains and pay no tax.  This could be tax paradise for those who carefully plan their transactions.

The conventional strategy in the past was to offset as much of your gains as possible with losses from selling other assets in your portfolio.  If you have an overall loss, then it is limited to $3,000 ($1,500 for married taxpayers filing separately), and any excess carries over to the next year.  Keep in mind that losses from the sale of business assets are generally separately allowed in full in the year of sale, and not mixed with the losses from the sale of other capital assets.  So with the benefit of the zero tax rate, a new strategy emerges: it may be more appropriate to take gains to the extent they would be taxed at zero percent.

What this zero tax rate means to you is that there is no tax on your long-term capital gains and qualified dividends to the extent that your regular tax rate is 15% or less. Remember that the gain and dividends themselves add to your income, impact income-based limitations, and may possibly push you into a higher regular tax bracket, so it is a balancing act to take advantage of this zero rate.  Of course, you can also use losses to offset the gains, but you should only have enough losses to keep the gain within the zero tax rate. 

The zero tax rate applies to the amount of your taxable income below the 25% tax bracket. For 2017, this “breakpoint” is the “top” of the 15% bracket and is:

  • $37,950(up from $37,650 in 2016) for single taxpayers and married taxpayers filing separate returns;
  • $75,900(up from $75,300 in 2016) for married taxpayers filing joint returns and surviving spouses; and 
  • $50,800(up from $50,400 in 2016) for heads of households 
  • Thus, the amount of your adjusted net capital gain taxed at 0% is:


(1) The breakpoint amount for your filing status, minus

(2) Your “other” taxable income (taxable income reduced by adjusted net capital gain).


The following issues may also come into play when planning your capital gains and losses strategies:

(1) Gains from the sale of inherited capital assets are automatically long-term (with the possible exception of certain assets inherited from decedents who died in 2010); 

(2) By election, long-term capital gains can be used to increase the amount of investment income when figuring the investment interest deduction, but then aren’t eligible for the lower capital gain tax rates;

(3) Losses from selling personal-use capital assets, such as your home or auto, are not deductible and cannot be used to offset gains, and

(4) You may have short- and/or long-term capital losses from a prior year to account for.  Also take into consideration how your state taxes capital gains; most do not have a 0% LTCG rate, and many do not have any special rates for capital gains.

Please give our office a call so that we can help you develop a strategy that will suit your unique situation.

* Net capital gain is generally the excess of net long-term capital gains over net short-term capital losses, subject to certain netting rules.  However, the zero tax rate doesn't apply to collectibles gain or gain taxed on sales of certain small business stock, both taxed at a maximum rate of 28%, or to unrecaptured Sec. 1250 (depreciation) gain, which is taxed at a maximum rate of 25%. 

Deducting Investment Interest

Generally, the only interest deductible on the Schedule A (where deductions are itemized) is home mortgage interest, with one exception, investment interest. Investment interest can be interest you pay on your brokerage margin account, interest on investment property such as land, etc. However, this interest deduction is limited to "net investment income." In layman's terms, you can only deduct the interest expense to the extent you have investment income.

And to complicate matters further, the term "Net Investment Income" refers to investment income less any investment expenses. For example, you own vacant land and your annual property taxes on that land are $500. The property taxes are treated as investment expenses. You also have interest income of $1,200 for the year. Your net investment income is $700 (the $1,200 interest income less the $500 property tax expense). Therefore, you would be able to deduct $700 of investment interest for the year. If your investment interest exceeded the $700, the excess would carry over to the next year.

In a taxable year where there is a capital gain, the taxpayer can elect to treat any portion of that gain as investment income. If that election is made, then the taxpayer must treat the elected capital gains as ordinary income. This prevents a taxpayer from receiving the favorable capital gains tax rates and a deduction for investment interest based on the same net investment income.

Deductions for Investors

The costs associated to your investments are deductible as a miscellaneous itemized deduction, subject to the 2% of gross income (AGI) limitation. Although they may seem trivial, it's still worthwhile to keep track of them as they can add up quickly. Combined with other allowable deductions, they can reduce your taxable income. Keep in mind, however, that investment expenses associated with tax-exempt income are not deductible. If the expenses are associated with both, you will need to prorate the expenses. The following are typical investment expenses you can deduct:
  • Investment Management Fees - You can deduct payments to a broker or an investment manager or advisor to manage your stocks and other investments.

  • Investment Publications & Periodicals - Books and periodicals related to investments and investing. Newspapers and other such publications of general application are not deductible.

  • Investment Travel - Traveling costs related to your investments, such as trips to your broker or investment advisor and trips to look after investment property. The costs must be reasonable, and you must be prepared to prove the reasons for your travel in case of an inquiry by the IRS.  Travel, and other expenses, to attend an investment-related meeting, seminar or convention are not deductible.

  • Meals & Entertainment - One-half of the cost of your meals or entertaining costs in connection with your investments. For example, if you took your investment advisor to lunch to discuss investments.

  • Legal Fees - Legal advice relating to your investments. If the legal services pertained to more than your investments, include only the portion of the fees that can be allocated to your investments.  Some legal expenses may not be deductible currently but may be used to increase your basis in the investment property.

  • Professional Fees – As an example, you can deduct fees you paid to your accountant for tax advice relating to investment transactions.

  • Safe Deposit Box Fees – Only to the extent that you store your investment documents.

  • IRA or Keogh Custodian Fees – Provided you pay them directly to the custodian. If they are paid from the IRA or Keogh account assets, they are not deductible.

  • Dividend Reinvestment – You can deduct service charges as part of a dividend reinvestment plan.

  • Insurance Premiums – Cost of insurance to protect your investments.

  • Home Computer Costs - If you use the computer to manage your investment activities. However, you generally must depreciate the computer using the straight-line method and allocate between investment and personal use.

  • Software –The cost of software used to manage your investments. If the software has a life of over one year and the cost is $200 or more, you may need to depreciate the software.

  • Office Rent – Rented property you use to manage your investments.

  • Collection/Broker Fees – Paid to a broker, bank, trustee or agent to collect taxable bond and note interest or dividends. This doesn't include broker’s commissions on the purchase or sale of securities.

  • Replacing Lost or Missing Securities - If you have taxable securities (e.g., stock certificates or bonds) that are lost, stolen, destroyed or mislaid, you may have to post an indemnity bond to get them replaced. The premium to buy the indemnity bond, net of any refund if the missing securities are recovered, is deductible.

Fine-Tuning Capital Gains and Losses

The year’s end has historically been a good time to plan tax savings by carefully structuring capital gains and losses. Let’s consider some possibilities.

If there are losses to date
- As an example, suppose the stocks and other capital assets that were sold already during the year result in a net loss and that there are other investment assets still owned by the taxpayer that have appreciated in value. Consideration should be given to whether any of the appreciated assets should be sold (if their value has peaked), and thereby offset those gains with pre-existing losses.

Long-term capital losses offset long-term capital gains before they offset short-term capital gains. Similarly, short-term capital losses offset short-term capital gains before they offset long-term capital gains. Keep in mind that taxpayers may use up to $3,000 of total capital losses in excess of total capital gains as a deduction against ordinary income in computing adjusted gross income or AGI. Individuals are subject to tax at a rate as high as 39.6% on short-term capital gains and ordinary income. But long-term capital gains are generally taxed at a maximum rate of 20%.

All of this means that having long-term capital losses offset long-term capital gains should be avoided, since those losses will be more valuable if they are used to offset short-term capital gains or ordinary income. Avoiding this requires making sure that the long-term capital losses are not taken in the same year as the long-term capital gains. However, this is not just a tax issue; investment factors also need to be considered. It would not be wise to defer recognizing gain until the following year if there is too much risk that the property’s value will decline before it can be sold. Similarly, one wouldn't want to risk increasing a loss on property that is expected to continue declining in value by deferring its sale until the following year.

To the extent that taking long-term capital losses in a different year than long-term capital gains is consistent with good investment planning, a taxpayer should take steps to prevent those losses from offsetting those gains.

If there are no net capital losses so far for the year
– If a taxpayer expects to realize such losses in the subsequent year well in excess of the $3,000 ceiling, consider shifting some of the sales and resulting excess losses into the current year. That way, the losses can offset current year gains, and up to $3,000 of any excess loss will become deductible against ordinary income in the subsequent year.

For the reasons outlined above, paper losses or gains on stocks may be worth recognizing this year in some situations. But if the sale would result in a loss and the stock is to be repurchased, it cannot be repurchased within a 61-day period (30 days before or 30 days after the date of sale) under the “wash sale” rules. If it is, the loss will not be recognized and will simply adjust the tax basis of the reacquired stock.

Careful handling of capital gains and losses can save substantial amounts of tax. Please contact this office to discuss year-end planning strategies that apply to your particular situation so as to maximize tax savings.

Capital Gains Tax on Inherited Assets

When an asset is sold, the owner owes capital gains tax on the profit. For these purposes, "profit" is the excess of the sales price over the owner's tax basis in the property. If the owner bought the property, his or her tax basis is generally equal to what he or she paid for it. Under the current rules, a beneficiary who inherits an asset is generally allowed to use the asset's value on the date the deceased owner died as his or her tax basis in the asset. Because of this "step up" or "step down" in basis, only the post-death appreciation is subject to income tax if the beneficiary decides to sell the asset. In addition, inherited assets are treated as if held long-term by the beneficiary, even if the assets would have received short-term treatment in the hands of the decedent.

For assets inherited from decedents who died during 2010, the beneficiaries' basis will depend on whether the estate was subject to the estate tax or elected out of the tax and chose instead for the beneficiaries’ basis to be determined under the modified carryover basis regime.  Estates with assets valued at $5 million or less generally elected to be subject to the estate tax system  since an estate could have had up to $5 million of assets and still paid no tax, and the beneficiaries would have received a basis equal to the properties’ fair market value at date of death.  Regardless of which method the executor selected - estate tax with stepped up/down basis for the assets or the modified carryover basis—a beneficiary should have received information from the executor as to the basis of assets that he or she inherited.

Common Investment Errors

There are a number of ways that a little knowledge can be a risky thing when dealing with investments. Following is a brief overview of some common mistakes made by investors.
  • Investing based on a cold call from an unknown broker. This is generally always a mistake.

  • Assuming you can exchange fund shares without triggering a gain. Many fund families provide fund exchange privileges, allowing you to freely exchange funds within the family of funds. However, the exchanges are taxable events and any gain or loss from each exchange must be accounted for on your tax return for the year of the exchange.  

  • Buying last year's hot investment. A previously rising star often has risen near its peak. Your late investment may have nowhere to go but down.

  • Neglecting to periodically review your investments. If you like to buy and hold your investments, you may have a tendency to leave your investments alone for too long. Your allocations should be reviewed regularly.

  • Having a belief that "fixed income" is also "fixed value." Just because the income rate is fixed for a bond, its value is not. In a time of rising interest rates, bond values can decrease.

  • Equating high yields with high returns. Yield only deals with the income stream of an investment. Other factors, such as risk and volatility, can determine the underlying value of the investment. Both are necessary to achieve high returns.

  • Presuming that all investment products sold by banks are insured. Many banks now offer more than their traditional products and generally these nontraditional products are not FDIC insured.

  • Buying mutual fund shares late in the year. Almost all mutual funds make annual capital gain allocations late in the year, generally December. If you purchase right before these allocations, you'll receive significant taxable income even though you've only owned the fund for a small portion of the year.

  • Writing checks on mutual fund accounts. Many mutual funds allow checks to be written against the account. Writing these checks can trigger a sale of fund shares that can be a taxable event.

  • Forgetting about the "wash sale" rules. Re-purchasing a stock or a mutual fund (including reinvested dividends) that you sold at a loss within thirty days of the previous sale results in the loss becoming nondeductible for tax purposes.

  • Relying on hot tips. Remember, if it sounds too good to be true, it probably isn't true.

Investment Tax Blunders to Avoid

If you can avoid the top ten investment blunders, you will save money on your taxes and perhaps even increase the returns on your investments. We realize that a mid-year review of your tax situation may not be at the top of your “to-do” list, but think of it this way: devoting a few minutes now could save you big bucks at tax time.

By following these tips, you can reduce your taxes for the year and even increase the after-tax return on some of your investments:

1. Anticipate distributions from declining funds - Since mutual funds are required to distribute capital gains to shareholders, you might receive a taxable distribution even though there was a decline in the share price of your fund this year. By preparing yourself and setting aside cash, you can avoid scrambling to pay taxes in April.

2. Purchase shares after the next scheduled distribution - Don’t buy a mutual fund shortly before a capital gains distribution since a portion of your investment will almost immediately be handed back to you. This will have you owing tax on the distribution with less money to reinvest.

3. Be prudent with “tax-exempt” investments - Although the income from “tax-exempt” investments is generally nontaxable, funds will sometimes throw off capital gains distributions. This happens when the fund managers sell bonds, which can produce a taxable capital gain, and then buy other bonds. This can aggravate fund investors who don’t expect to pay taxes on these types of investments.

In addition, if you want the income to be tax-exempt for state income tax purposes, you need to make sure the fund is invested in your resident state muni-bonds since most states treat as taxable muni-bond interest derived from other states. Another common mistake is failing to change funds when you move from one state to another.

If you are subject to the alternative minimum tax (AMT), be aware that interest from most “private activity” muni-bonds is tax-exempt for regular tax purposes but not for AMT purposes.

As part of the health-care related Affordable Care Act, the net investment income of higher income taxpayers is subject to the net investment income tax (NIIT), which is a 3.8% surtax on the lesser of their modified adjusted gross income that exceeds a filing-status based threshold amount or  their investment income less investment expenses. For surtax purposes, gross income doesn't include interest on tax-exempt bonds, which weighs in favor of owning tax-exempt bonds.

4. Time your fund transfers wisely - Frequently, people sell one bond fund or mutual fund to buy another as a way of rebalancing their portfolio. However, for tax purposes, that represents a sale of a security and the purchase of another. Thus, you will need to account for the gain or loss from the fund sold on your tax return. This is generally an unpleasant surprise to those unaware of this rule, especially if there is significant gain to report on the sale. If there is a loss, selling the fund during the current year will allow you to utilize the loss now (within the limits explained in #8 below). However, if there is a gain, consider waiting until just after the first of the year so that you can defer the gain---but this strategy may not be appropriate for someone who can take advantage of the 0% long-term capital gain tax rate.

5. Contribute the maximum - If you maximize your retirement plan contributions, it will help maintain your current lifestyle years from now. In addition, it may also reduce this year’s taxable income.

6. Say “no” to tax-free investments in tax-sheltered plans - Instead of concentrating on annuities or municipal bonds, you’ll do better with high-yielding income and growth-oriented investments.

7. Sell a loser - There probably isn’t a stock market investor who isn’t holding a stock that is worth less now than when it was bought. Selling a loser in a taxable account can save you money and free up cash for investments with more potential. This is because the IRS allows investors to offset realized gains with realized losses. In addition, $3,000 in additional losses can be used to reduce your taxable income. Don’t sell for tax reasons alone, especially if you are confident that your dogs will turn into dream stocks. Just keep in mind that if a stock has dropped in price by 50%, it will need to gain 100% in order to break even.

8. Be aware of the limit on losses - If you are thinking of cashing in all your dogs, consider that losses are limited to offsetting realized gains and up to $3,000 in ordinary income. Although losses higher than this amount can be carried over for use in the future, they would be of no benefit to you this year.

9. Stay away from wash sales - If you would like to offset gains with losses, try and avoid “wash sales” since the IRS doesn’t allow you to recognize the loss on such sales. A wash sale occurs when a security is sold at a loss and then repurchased within 30 days before or after the date it was sold.

Don’t fret. One way you can realize losses and keep your portfolio balanced is to sell and buy back a security 31 days after the sale. Individuals who cannot wait for that period of time should purchase a similar security (not identical) to the one that was sold.

10. Check your cost basis when you sell - Although most people remember to include commissions on trades or mutual fund transaction fees when calculating cost basis, many fail to consider the dividend money that has automatically been reinvested, which results in taxpayers overpaying on taxes. Most commonly dividend reinvestment occurs with mutual funds but some companies also have dividend reinvestment plans for individual stockholders. Reinvested capital gains and dividends can add quite a bit to cost basis and make gains much smaller.

Review all your purchases when it comes time to sell. You will have a smaller taxable gain and a much better idea of your actual return on a fund.

As an investor, you want what’s best for your money. Be prepared and avoid the unnecessary headache at tax time. If you have specific concerns regarding your investments, please call our office so we can discuss them in detail.

Some Common Investments Enjoy Preferential Tax Treatment

Although there are a variety of sophisticated tax shelters available, our tax laws also afford special tax treatment to certain common types of investments. Used appropriately in conjunction with sound tax and investment planning, these special benefits may produce a higher after-tax return on your investment dollars.

Dividends:
Most dividends received by an individual shareholder from domestic corporations (and certain foreign corporations) are treated as net capital gain for purposes of applying the capital gain tax rates. This means qualifying dividends are taxed at 0% for those in the 10% and 15% tax brackets, 15% for taxpayers in the 25% through the 35% brackets and 20% for taxpayers whose tax bracket is 39.6%. The net tax savings for each marginal tax bracket is illustrated below.

Tax Bracket
Qualified Dividend Rate
Net Tax Savings
10%
15%
25%
28%
33%
35%
39.6%
0%
0%
15%
15%
15%
15%
20%
10%
15%
10%
13%
18%
20%
19.6%


Even though qualified dividends are taxed the same way as capital gains, dividend income cannot be offset with capital losses. Dividends on stock held in a retirement plan or traditional IRA will not benefit from the lower rates; distributions from these plans continue to be taxed at ordinary income rates.

Municipal Bonds: Although they generally pay a lower interest rate, their "after- tax" return can be higher than other similar investments such as corporate bonds, CDs, etc. Taxpayers in higher tax brackets and children subject to the "kiddie tax" frequently use this investment. If your state has income tax, you should note that most states will only allow the exclusion of interest on municipal bonds issued from that particular state or municipalities within that state. Municipal bonds can be purchased directly or investments can be made through a variety of municipal bond funds, many of which specialize in bonds from a specific state. Taxpayers drawing Social Security benefits should be reminded that even though municipal bond income may be tax-free, it is still used as income for purposes of determining the taxable portion of Social Security income.

Capital Gains: Gain from investments such as stocks, mutual funds, land, real estate, etc., are taxed at rates lower than an individual's regular tax rate if they are held over one year. Gains from such assets are generally taxed at 0% if you are in the 10% or 15% tax bracket or 15% if you are in the 25% through 35% bracket and 20% if you are in the 39.6% tax bracket.

Interest for Direct U.S. Government Obligations: This category includes U.S. Savings Bonds, T-Bills, HH Bonds, etc. Interest earned on these obligations is taxable only for Federal purposes. Federal law prohibits states from taking a bite out of this income. Taxpayers that wish to reduce their state tax liability will greatly benefit from these investments. In addition, Series E, (No longer issued), EE and I Savings Bond interest can be deferred until the bonds are cashed or reach maturity, providing a valuable tool for deferring income to some future tax year. Children, who are still dependents of their parents and have a lower standard deduction, can use the bonds to defer their income to a year when they get benefit of the full standard deduction, personal exemption, and lower tax rate. If that same child attends college, they may be able to offset the income with education credits.

Education Savings Bonds: Interest you receive from the redemption of U.S Series-EE savings bonds purchased after 1989, or Series I bonds, and after attaining the age of 24, held in your name or jointly with your spouse, may be excluded from income to the extent you pay qualified higher education expenses. The expenses must be for you, your spouse or a dependent and must have been paid during the same year the bonds were redeemed. The tax benefit has limited application since the benefit is phased out for taxpayers with higher incomes. For 2016, the phase out begins at $ 77,550 (up from $76,200 in 2015) for singles and $116,300 (up from $115,750 in 2015) for those filing jointly. The exclusion is completely phased out by the time singles reach $92,500 (up from $92,200 in 2015) and $146,300 (up from $145,750 in 2014) for joint filers. If you are considering this strategy, keep in mind the income phase out is based on the year the bonds are redeemed and not the year they are purchased.

If we can assist you with the application of any of these strategies to your particular situation, please give us a call.

Is Life Insurance a Sound Investment?

Most people don't look at life insurance from an investment perspective. However, it is becoming a popular option among corporations and trusts because it provides the best after-tax returns compared to other investment vehicles.

The easiest way to see what life insurance can and cannot do is to make a simple comparison with other investment options. Make sure that the comparison is fair and that all costs, including tax effects, are analyzed on a year-to-year basis for both the insurance and the alternative investment. Don't use investments that have completely different risk profiles; your comparison results will not be accurate.

If it is properly structured, life insurance can provide the following tax advantages:

  • Your heirs will receive the death benefits tax-free.

  • The cash values grow tax-deferred and any withdrawals are tax-free until the cumulative investment (in the contract) is recovered.

  • A loan from the policy is not taxed as income.

  • The death benefit will pay off any outstanding loan balances income tax-free at the time of death. The death proceeds can even be estate tax-free if the policy is owned by an Irrevocable Trust.

A life insurance program can be customized to meet your individual needs and objectives. If you are after the tax-advantaged cash value accumulation, you can minimize the life insurance benefit. In many cases though, the benefit is the most valuable feature since it immediately creates a capital sum at death that cannot be duplicated by any investment.

If you would like to discuss the tax benefits of a life insurance investment, please contact our office.

Is Long-Term Worth the Wait and Risk?

Gains from the sale of capital assets such as stocks and other securities held over a year are referred to as long-term capital gains, while those held for shorter periods are called short-term. Long-term gains enjoy special tax treatment while short-term gains are taxed as ordinary income.

It is frequently asked if it is worth the risk holding a security long-term versus cashing in on short-term gain. Of course, no one has a crystal ball that can predict the future performance of a particular stock or the market in general, but we can provide some guidelines that will help you with your risk-reward analysis. The following chart illustrates the difference between short- and long-term capital gains rates and the net savings based on a taxpayer's tax bracket. Keep in mind that your tax bracket is also a function of your total income including the capital gains. Therefore, the larger the gain, the greater the chance you will move into a higher tax bracket.


Tax Bracket
Short-Term
Rate
Long-Term
Rate
Net Long-Term Savings
10%
10%
0%
10%
15%
15%
0%
15%
25%
25%
15%
10%
28%
28%
15%
13%
33%
33%
15%
18%
35%
35%
15%
20%
39.6%
39.6%
20%
19.6%

 

As an example, suppose you are in the 28% tax bracket and have a potential $10,000 capital gain. The tax for short-term gain is 28% or $2,800. On the other hand, if you held the asset for over a year, the gain would be taxed at 15% or $1,500. Your savings would be $1,300.

Now it is up to you to decide whether the savings of $1,300 is worth the risk of holding the stock until it qualifies as long-term.

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