B. Cut Taxes On Your Investments


Long-term capital gains tax rates will produce automatic tax savings by taxing the gain from capital assets at rates lower than the regular tax rate. To take advantage of the long-term rates, you need to hold the asset longer than one year. The long-term rate depends on two things: your marginal tax rate and how long you have held the asset.

  • If your marginal rate is 15% or under - Your long-term capital gains rate for 2007* will be 5% for property held longer than one year.

  • If your marginal rate is above 15% - Your long-term capital gains rate for 2007* will be 15% for property held longer than one year.

* These rates are in effect through 2010. After 2010 long term capital gains currently taxed at 5% (or zero percent as discussed below) will be taxed at a rate of 10% (8% for assets held over five years), and long-term capital gains now taxed at a rate of 15% will be taxed at a rate of 20% (18% for assets held over five years).

** The 5% rate becomes zero percent in 2008 through 2010.

Taxpayers in the 15% or less tax brackets with unrealized long-term capital gains should develop strategies to take advantage of the “zero” tax rates in 2008 through 2010, possibly cashing in on existing gains while avoiding any federal tax on the gains. However, this strategy is only applicable when there is no significant risk of value decline while waiting for the “zero tax” window. Also remember the gain itself adds to the taxpayer’s income, impacts income-based limitations, and possibly pushes the taxpayer into a higher regular tax bracket, so it is a balancing act to take advantage of this zero rate.

Primarily because of this zero tax rate beginning in 2008, Congress raised the age for the “kiddie” tax to include full-time students under the age of 25 (See chapter 8.02 for the “kiddie” tax). Thus, Congress effectively nullified a popular strategy for funding college expenses by gifting appreciated stock to children who could then sell it with no or reduced tax liability.

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 ($1,500 for taxpayers filing as married separate) of total capital losses in excess of total capital gains as a deduction against ordinary income in computing adjusted gross income or AGI. For 2007, individuals are subject to tax at a rate as high as 35% on short-term capital gains and ordinary income. But long-term capital gains are generally taxed at a maximum rate of 15%.

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.

Special Considerations - Some long-term gains are treated differently. Long-term gain attributable to depreciation recaptured on certain depreciable real estate is taxed at a maximum rate of 25%, and long-term gain attributable to collectibles (works of art, coins, stamps, antiques and similar property) is taxed at a maximum of 28%. If a taxpayer owns shares of the same stock purchased at different times and prices and can specifically identify those blocks of stock, it may be to his or her benefit to pick the block of shares to sell based on their cost and holding period. If the taxpayer cannot specifically identify them, then the first-in first-out rule applies. Shareholders of mutual funds may choose to average the cost basis of shares bought at different times; for holding period purposes, the mutual fund shares that are sold are considered to be the ones acquired first.

When deciding whether to take gain or hold for long-term rates, compare the savings associated with long-term rates to the financial risk of continuing to hold the investment. 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. Owners of luxury homes with gains exceeding the $250,000/$500,000 exclusion limits, and owners of second homes that do not qualify for the home sale gain exclusion, will especially benefit from the lower capital gain rates.


Dividends

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 dividends are taxed at no more than 15% for taxpayers whose marginal rate is above 15% and 5%* for those in the 10% and 15% tax brackets. Capital losses cannot offset the dividend income. Dividends on stock held in a retirement plan or Traditional IRA do not benefit from the lower rates; distributions from these plans are taxed at ordinary income rates.

* The 5% rate becomes zero percent in 2008 through 2010.

Deferring or Avoiding Tax When Disposing of Assets

Depending on the type of asset, there are a number of strategies that can be employed to reduce, defer, or even avoid the tax upon the asset’s disposition.

  • Tax-Free Exchange - Commonly referred to as a Sec 1031 exchange in reference to the tax code section covering exchanges, this type of strategy is frequently used to defer taxes in real estate held for business or investment purposes by deferring the gain into a replacement real estate property also held for business or investment purposes. Tax-free exchanges are also available for non-real estate business assets, but must conform to stringent like-for-like requirements. Tax-free exchanges do not apply to personal-use real estate holdings, such as your home or second home, and generally do not apply to publicly-traded stock. If the property is mixed-use property, such as a house that is used partially as a home, the business portion may qualify under the Sec 1031 exchange rules. Please call this office for additional details.

  • Installment Sale - By carrying back the paper (loan) on the sale of an asset, you can spread the gain over a period of years. In these types of arrangements, the gain and nontaxable return of capital are taxed proportionally over the term of the sale agreement, thereby deferring the tax on the gain portion until actually received.

  • Charitable Gift - Consider replacing cash charitable gifts with gifts of appreciated property. By giving the asset to a favorite charity, the taxpayer receives a charitable contribution deduction equal to the fair market value of the gift and at the same time avoids having to report the gain from the asset on his or her return. However, the maximum deduction for gifts of this type can be as low as 20% or 30% of AGI as compared to 50% for cash gifts. Caution: If the value of the stock a taxpayer is considering gifting is less than what was paid for it, he or she should sell it, take the loss on their return and then contribute the cash to the charity.

  • Charitable Remainder Trust - This technique allows a taxpayer to contribute his or her asset(s) to a trust, which in turn pays an income during the remainder of the taxpayer's life and leaves the balance at death to the charity. The assets contributed to the trust can be sold within the trust without any tax consequences to the taxpayer. In addition, when the trust is formed, the taxpayer will receive a charitable deduction for the estimated amount that the trust will leave to charity upon death. The amount of income paid to the taxpayer each year is flexible (within some limitations) and provides annual funds, which can then supplement retirement needs.

  • Gifts to Individuals - Giving a gift of appreciated property to an individual (donee) transfers the gain from that property to the donee. This can work to your advantage by gifting the appreciated asset rather than giving the donee cash. Let’s say that a taxpayer is paying for a child’s college education. Instead of selling some appreciated stock to pay for the schooling, the stock should be gifted to the student, who can sell it in a much lower tax bracket and pay for his or her own school expenses. The foregoing are abbreviated summaries of tax strategies that may have additional restrictions or other tax ramifications. Please consult with this office before attempting to employ any of these strategies.

The foregoing are abbreviated summaries of tax strategies that may have additional restrictions or other tax ramifications. Please consult with this office before attempting to employ any of these strategies.


Take Investment Losses

If a taxpayer has investments that are worth less than what was paid for them, he or she can use the losses to offset other gains and in certain circumstances other types of income.

  • Capital Losses - Tax law allows you as an investor to offset capital gains with capital losses, and if the losses exceed the gains, one can deduct losses up to a maximum of $3,000 ($1,500 if filing married separate) for the tax year. Any additional losses carry over to future years. For this reason, review your securities portfolio at year’s end and search for stocks and other securities whose sales will result in a capital loss. This will help minimize your gains or maximize your losses for the year. When planning this strategy, keep in mind that under the wash sale rules, a loss is disallowed if the security sold at a loss is repurchased within 30 days. A loss will also be disallowed if the investor buys the same security 30 days before the sale.

    Another planning strategy is to avoid having long-term capital losses offset long-term capital gains, 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.
  • Variable Annuity Losses - If a taxpayer has a variable annuity that is worth less than what was paid for it, consider surrendering it before year’s end so that a deductible loss can be realized. Usually, the amount that is deductible will be the surrender value less the tax basis in the annuity. The tax basis is generally the amount originally invested less any amounts previously received from the annuity that were excludable from income. Before making a decision to surrender, consider any possible surrender penalties and the potential for the annuity to recover. Please call this office if we can assist you with your decision.


Invest in Tax-Exempt Securities

  • Municipal Bonds - Interest received on obligations of states and their municipalities is exempt from Federal tax and may also be free from state taxation. Although these bonds generally pay a lower interest rate, their “after-tax” return (yield) 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. 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. In addition, interest on certain “private activity bonds” is not exempt for AMT purposes.


    EQUIVALENT TAXABLE YIELD
    Tax
    Exempt
    Tax Equivalent Taxable Yield Marginal Tax Rate
    10
    15
    27
    30
    35
    38.6
    2.0
    2.2
    2.4
    2.7
    2.9
    3.1
    3.3
    2.5
    2.8
    2.9
    3.4
    3.6
    3.8
    4.1
    3.0
    3.3
    3.5
    4.1
    4.3
    4.6
    4.9
    3.5
    3.9
    4.1
    4.8
    5.0
    5.4
    5.7
    4.0
    4.4
    4.7
    5.5
    5.7
    6.2
    6.5
    4.5
    5.0
    5.3
    6.2
    6.4
    6.9
    7.3
    5.0
    5.6
    5.9
    6.8
    7.1
    7.7
    8.1
    5.5
    6.1
    6.5
    7.5
    7.9
    8.5
    9.0
    6.0
    6.7
    7.1
    8.2
    8.6
    9.2
    9.8


  • Direct U.S. Government Obligations - Interest from U.S. Savings Bonds, T-Bills, H Bonds, etc. is taxable only for Federal purposes. Federal law prohibits states from taking a bite out of this income. In addition, interest from U.S. Savings Bonds may be deferred until the year the bond is cashed, providing a vehicle for deferral strategies.