TAX SECRETS FOR INVESTORS
By: Irving Blackman
The tax swap is a device that generates paper losses to shelter real income from taxes.
How it works: An investor examines his portfolio to find securities that have gone down in value since being acquired, He sells these securities to generate a loss, then immediately reinvests the sale proceeds in the purchase of similar securities.
The sale generates a capital loss that can be used to offset any capital gains received during the year plus up to $3,000 in ordinary income, sheltering these amounts from tax. But the loss occurs only on paper, since the value of the investor’s portfolio remains approximately the same.
What’s similar: When a bond is sold, a similar bond might be one of a different company with the same coupon, maturity date and credit rating. Or it might be one of the same company with a slightly different coupon and maturity date.
When stock is sold, a similar stock might be that of a different company in the same business,
Alternative: You can reinvest the sale proceeds in the same securities that were sold, after waiting a period of 31 days (the “wash sale” rule). Caution: If you do not wait the full 31 days, the loss on the sale will not be recognized for tax purposes.
BUYING BONDS ANONYMOUSLY
Bearer bonds, although a perfectly legitimate form of debt security, have become a favorite investment for the underground economy. Why: They are a convenient way to stash cash, earn interest on it, and (illegally) hide that income from the IRS. This is possible because bearer bonds are not registered in the purchaser’s name. They belong to anyone who possesses (bears) them.
Types of bonds that are bought in bearer form:
*Corporate issues predating the late 1960s. (After that, the Department of the Treasury required corporate bonds to be registered when sold.)
*Treasury notes and bonds (but not Treasury bills.)
*Most federal government agency securities (such as GNMAs.)
*Virtually all state and municipal issues.
Dangers: If lost or stolen, bearer-bond certificates are, for all practical purposes, impossible to trace and recover. Because there is no name on them, investors risk having someone else (perhaps a family member) cash them in without permission. And if the interest is not declared as income, and the IRS discovers the concealment, the bondholder faces criminal as well as civil penalties.
BEATING THE “WASH SALE” RULE
Suppose you own stock that has gone way down, but you still think it’s worth holding. You can sell $2,000 worth, put the cash in an IRA, and have the IRA buy back the stock. You get a capital-loss deduction on your tax return. “Wash sale” rules didn’t apply, as it was not you, but a different legal entity that made the repurchase.
HOW TO AVOID TAX ON DIVIDENDS
Individuals can avoid paying taxes on dividends earned from stock investments by investing through a tax managed mutual fund.
How it works: The individual buys shares in the fund. The fund invests in stocks. Dividends are not passed through to the investor, so they are not taxed to him. Instead, they are reinvested in further stock purchases. In this way, the fund grows for the investor’s benefit.
How to buy: Shares in a tax managed fund can be acquired through a broker. These funds are generally invested in utilities and steady stocks that pay high dividends, such as AT&T, IBM and GM. So they tend to rise less than the average stock in a bull market and fall less than average in a down market. These funds charge annual management fees averaging about 0.75%, plus up-front “load” fees ranging from 6.75% to 8.5% of the investment. So be sure to consult with an investment adviser and pick a fund that suits your particular needs.
Source: Andrew J. Donohue, secretary and counsel, First Investors
Corporation, 120 Wall St., New York 10005.
FIGURE THE REAL YIELD ON YOUR BONDS
With the disappearance of so many other tax-favored investments, municipals have a lot of appeal. Before vou buy, though, be sure to compare them to the after-tax yield of other investments. Prices, as well as interest rates of new municipals, will inevitably be affected because of the new, lower federal tax brackets. For example, a tax-exempt issue paying 10 percent was equivalent to a taxable one that paid 20 percent when the owner was taxed at the old 50 percent maximum tax rate. At the 28 percent bracket, the 10 percent muni is equivalent to a fully taxable bond that pays 13.89 percent. That assumes that bonds are traded at par-exactly 100 percent of face value -which is not very common. So the alert investor will check on “yield to maturity,” which also accounts for any discount or premium paid when a bond is purchased. “Yield to maturity” is the primary yardstick used to measure bond yield and is an important way to compare taxable issues with
nontaxables, for example.
Whether it relates to municipals or taxable bonds, current yield does not take into account and gain or loss; yield to maturity does. For example, if a 30-year bond that pays $80 a year sells for $1,000 par, it has an 8 percent yield. A different bond may pay only $62 a year but have a yield to maturity of 8 percent also, because it sells for $775 instead of $1,000. Yield to maturity is based on the price and assumes that the periodic payments are reinvested until the bond matures. In other words, it takes the time value of money into account on an annual basis. Check with your
broker. He or she will have a Yiele-to-Maturity Table in a yield book.
MUNICIPAL BONDS TAX TRAP
Many taxpayers misreport income from municipal bonds. They unwittingly raise their taxes in the process.
Example: A state or city issues a bond with a face value of $1,000 that bears 7% interest ($70 a year). But market forces say the bond should pay 10%. So it is actually sold for a price that is closer to $700 (on which $70 would be 10% interest). A taxpayer buys the bond and holds it to maturity. Typical mistake: When the taxpayer cashes the bond in for $1,000, he claims a $300 capital gain.
Trap: The increase in the value of the bond is not all capital gain. The IRS has held that any increase in value that is attributable to the discount given when the bond was originally issued is really interest income. Benefit to taxpayers: Interest on most municipal bonds is tax free.
Reality: A municipal bond is rarely held by the same person from the day it is issued until the day it matures, which may be many years later. It is much more likely that the bond will be traded several times during that period. And the price of a bond issued at discount will tend to rise as its maturity date approaches.
Tax treatment: The amount of the discount is attributed to the owners of the bond evenly over the bond’s life.
Example: A bond issued at a $300 discount has a 30-year term. The discount is attributed (or amortized) at the rate of $10 a year. So a person who holds
the bonds for two years may sell it for a $20 profit and have no taxable gain.
Complications: The price of the bond may be affected by many other factors. And a price change resulting from another factor, such as a change in interest rates, will result in a gain or loss that is capital in nature. But a taxpayer who properly amortizes the original issue discount will benefit regardless of whether the bond is sold for a gain or a loss.
Reason: The taxpayer adds the amortized discount to the price he paid for the bond when he computes his profit or loss on the subsequent sale.
Reason: If the bond is sold for a profit, the taxable gain is reduced. But if it is sold for a loss, the available loss deduction is increased.
Example: A bond issued at a $300 discount has a 30-year term. The discount is amortized at $10 a year. The bond is bought at some point by an individual for $750. Three years later it is sold for:
*$850. The individual’s taxable gain is only $70, not $100. Computation: The $850 sale price is reduced by both the $750 original purchase price and $30 of the amortized discount.
*$650. The individual’s deductible loss is $130, not $100. It is computed the same way.
Point: The favorable impact of the amortized discount will be larger if the bond is held longer.
What to do: Always consider the impact of the original issue discount on the after-tax profitability of a deal involving municipal bonds, And be sure to keep adequate records, so the impact can be determined.
AVOIDING THE 2% FLOOR FOR MISCELLANEOUS DEDUCTIONS
Miscellaneous itemized deductions include expenses directly connected with the production of investment income, such as…
1. Fees for managing investment property.
2. Legal and professional fees.
3. Fees for tax preparation and advice, investment advice and financial planning.
Problem: Most taxpayers are unable to deduct any investment expenses on Schedule A because their total miscellaneous expenses don’t exceed 2% of their Adjusted Gross Income.
Solution: Put as many expenses as possible out of reach of the 2% floor by accounting them elsewhere on your return, Possibilities:
*Schedule C. Report non-wage miscellaneous income, such as that earned from consulting, lecturing, or speaking engagements, on Schedule C as business income. The expenses you incur in producing that income are deductible on Schedule C, where they are not subject to the 2% floor.
*Schedule E. Expenses of earning rent, royalties, or other income that is reportable on Schedule E are deductible on Schedule E, where they are not subiect to the 2% floor.
*Adjust the cost of assets. Add the expenses of acquiring a capital asset to the asset’s cost. This will reduce the amount of capital gain you must report when you eventually sell. While this approach doesn’t give you a current deduction for the expenses, it does reduce the tax you pay on the gain.
*Bunch payment of expenses so that you get two years’ worth into one year and exceed the 2% floor in at least one year.
Source: Richard Lager, national director of tax practice, Grant Thornton, CPAs, 1850 M St. NW, Washington, DC 20036.
JOINT OWNERSHIP LOOPHOLE
A recently developed tax saving technique involves the joint acquisition of an asset by parties of noticeably different ages. An even more recent change in the tax law causes many careful tax practitioners to be wary, at least for now, of this joint ownership technique, especially when it is applied within family groups. Frankly, the change in the law is generally thought to be ill conceived and badly written. It is likely that carefully executed joint purchases will continue to achieve the desired tax results, though there are no guarantees in tax matters, of course.
The notion is simply that the parties of disparate ages acquire income-producing property jointly. Each party pays the actuarial value of his or her interest, based on tables provided by the Internal Revenue Service.
The older joint purchaser, by agreement, receives all the income produced by the property and pays more for it than the junior owner. The younger owner retains what is called a remainder interest. He or she will own the property completely, tax free, when the life interest of the senior owner ends.
Because the older owner pays less than the full amount for property that would, in all likelihood, be inherited by the younger owner, the yield is significantly improved. The technique is also very helpful when it comes to planning an estate because this jointly owned property, on the death of the senior owner, would go directly to the junior without passing through a taxable estate. (It escapes estate taxes, contrary to the general rule for jointly held property, because the decedent only had a life estate.)
Source: New Tax Loopholes For Investors by Robert Garber, Boardroom Classics, Springfield, NJ 07041.
REAL ESTATE TRAPS AND OPPORTUNITIES HIDDEN IN THE TAX LAW
The reformed tax laws present many ways for individuals to use real estate to slash their tax bills.
*Future gains shelter: While you cannot deduct real estate losses from salary or investment income, you can carry such losses forward to future years to offset future gains from real estate. For example, if you own property that’s appreciating in value, it may pay to hold it for a few years, then sell it and use your accumulated losses to shelter your gain from tax.
*Business property leasing: If you own your own business, you can retain personal ownership of real estate used by the business, then have the business lease the property from you. Advantages: You can set the terms of the lease (though it must provide for a rent that’s reasonable in relation to the market). Thus, you can fix the lease to provide you with income that will be sheltered from tax by losses you’re receiving from other investments. Or the lease can provide losses that you can use to shelter your other investment income.
*Under a special provision of the tax law, those with income of under $100,000 can still make direct investments in real estate and deduct up to $25,000 in losses each year. Thus, a person can buy an apartment or house, rent it out and use the tax losses that result to cut the taxes owed on salary or investment income. Requirements: You must own the property directly, not as an investor in a limited partnership. And you must actively manage the investment property yourself.
*Income deals: Most attractive under the new law will be real estate deals that are structured to produce annual cash flow for the investor. Because depreciation deductions are significant, this income can be sheltered from tax, with excess depreciation being accumulated to shelter ultimate gain when the property is sold. Result: The investor receives tax-free income similar to that which might be obtained from an investment in tax-exempt bonds-with a chance for additional large profits through the property’s appreciation.
Source: Glen Davis, partner, BDO Seidman, 15 Columbus Circle, New York 10023.
SUBSTITUTE FOR MUNICIPAL BONDS LOOPHOLE
To get muni-like tax-free income from rental real estate, buy the property with a low enough mortgage so that your deduction for depreciation equals the income the property earns. The lower mortgage interest payments make the cash flow, up to the depreciation amount, tax-free.
Opportunity: An arrangement of this kind is valuable for taxpayers with Adjusted Gross Income in excess of $150,000 who do not qualify for the $25,000 exception to the passive activity rules.
Source: Edward Mendlowitz, partner, Mendlowitz Weitsen, CPAs, Two
Pennsylvania Plaza, New York 10121. Mr. Mendlowitz is the author of several
books, including New Tax Traps/New Opportunities, Boardroom Classics,
Springfield, New Jersey 07041.
TRAPS IN REAL ESTATE
Every dollar the shelter’s management company takes out in fees is a dollar less to be distributed to the limited partners. In addition to fees for continuing to manage the property, the management company may get fees for selling the property at the end. It may also get a piece of the profit on final sale.
Areas of concern:
*Are the fees reasonable? Continuing management fees should not be more than 5%-6% of the gross rents.
*Does the total amount that the managers get from the project seem “fair”? This is something you must decide for yourself – at what point does the managers’ return affect your opinion of the whole deal?
*Do the managers get most of their fees up front? Better: Managers ride along with the investors and get their fees as they go along. That gives them a continuing stake in the property.
*Are the managing partners getting too big a share of the profit on sale? Has too large a fee been built into the selling price?
REDUCING THE TAX ON MUTUAL FUND GAINS
What has always been apparent to tax advisors seems to have escaped the attention of most taxpayers-that the way you keep your tax records can affect the amount of taxes you pay. An example can be found in bookkeeping for mutual fund purchases.
Mutual funds have always been a popular way to invest. Like many other investments, they can produce some nice gains, but when shares are sold it is possible to lose much of the profit through bad accounting. Lots of otherwise clever taxpayers have trouble figuring the tax cost basis of their shares in mutual funds for purposes of calculating gain or loss. That’s because fund shares may have been bought regularly over a period of time and because taxable income and capital gains may have been used to buy additional shares. The problem gets worse when shares are switched from fund to fund within a family of funds.
Providentially, IRS regulations offer alternative methods of bookkeeping for those taxpayers who have better things to do than keep track of each separate transaction in each lot of fund shares.
The first averaging method prescribed is the “single category method” and it is quite simple. Every share the taxpayer owns in a particular fund is considered as being in the same pot. Each share’s cost basis is the total adjusted cost of all the shares divided by the number of shares in the pot. The second system, the “double category method,” divides all the shares in the fund into two pots, one for short-term holdings and the other for shares held six months or longer. Each category is averaged separately as in the single category method. The double category method slides along with the calendar, obviously, and is thus a bit more bothersome. As you can imagine, this method was particularly useful when long-term gains were taxed at highly favored rates.
To use either of the two cost-averaging methods sanctioned by the regulations, fund shares must be left in an appropriate custody account maintained by an agent.
Then there is the “first-in, first-out,” or FIFO, method of accounting. It assumes simply that the earliest shares acquired that are still on hand are the first ones sold.
Even better is to sell the highest priced rather than the oldest shares first in order to reduce that taxable gain on the sale. To accomplish that, you must specifically identify each lot of fund shares by price or date acquired. That way the highest cost shares can be identified and the recognized gain reduced. Equally important, reinvested dividends will not be inadvertently taxed twice, first when they are distributed and immediately reinvested and again when the reinvestment shares are sold along with others with no indication that they cost anything in the first place. It’s not easy to maintain all those records, but it is likely to produce lower taxes.
Source: New Tax Loopholes for Investors by Robert Garber, Boardroom Classics, Springfield, NJ 07041.
(The above material was published by Boardroom Secrets, 1991.)
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