Capital Gains & Losses The capital gains tax affects millions of American investors. Capital gain is the profit you make on the sale of a nonbusiness investment, and certain business investments, that have increased in value. Tax Rates Gains on most assets held over a year will be treated as long-term capital gains and taxed at 15% for individuals in the top four tax brackets, and at 5% for individuals in the 10% or 15% tax brackets. From 2008 through 2010, investors in these bottom two brackets will pay zero tax on long-term gains. In 2011, favorable tax reform expires, and investors in the top four brackets will pay 20% on long term gains, while lower-income investors will pay 10%. Capital gains attributable to depreciation from real estate are taxed at a 25% rate, if it's held longer than 12 months. The gain on collectibles and certain small business stock is taxed at 28%. Timing Is Everything When it comes to investing, timing really is everything. Not only do you need to be concerned about an investment's price when you sell, but you should also look at whether selling makes sense from a tax standpoint. The 15% capital gain rate is quite favorable, but it only applies to investments held for more than 12 months. So, unless you're holding a really volatile stock where the bottom might drop out at any minute, hang on to it for at least a year. Even if the stock price drops a little, you may cut the taxes on the profit nearly in half if you wait. For example, if you sell stock that you have held for 11 months for a $10,000 gain and you're in the 35% bracket, your after-tax net proceeds would be $6,500. Alternatively, if you sell just one month and one day later for an $8,000 gain (20% less), your net proceeds would increase by $300 to $6,800 because because the lower 15% rate would apply. Timing is also important at the end of the year. If you've cashed in some big gains during the year, review your portfolio for unrealized losses. Take a hard look at any stocks which aren't likely to rebound in value. Sell them and use the losses to offset any gains you've realized. Always review gains and losses before the end of the year so you can offset gains and to make sure you've paid in enough estimated taxes to cover any gains. If you end up with more losses than gains, you can use $3,000 of it against other income and carry over the remainder of the losses to next year When selling shares of stock that you purchased at different prices at different times, inform your broker beforehand that you are selling the shares with the highest basis. This will minimize taxable gain or maximize deductible loss. Dividend Tax Rate Reduction Favorable Tax reform made a major change in the taxation of dividends. The tax rate on qualifying dividend income has been reduced to 15% for taxpayers in the top four brackets and to 5% (zero in 2008-2010) for those in the lowest tax brackets. The rate cut applies to dividends from domestic and qualified foreign corporations. This is a significant reduction from the ordinary income tax rates of 10% - 35%. Thanks to the Tax Increase Prevention and Reconciliation Act (TIPRA), passed in May 2006, the reduced tax rates are effective for dividends through 2010, and apply for both regular tax and AMT. Dividends subject to the reduced rates will not be "investment income" for purposes of investment interest expense unless you elect out of the reduced rates and treat the dividends as ordinary income. Reducing the dividend tax rate has related effects on corporations. The accumulated earnings tax rate is reduced to 15%. Personal holding company tax rate is reduced to 15%. The "collapsible corporation" rules are eliminated since the dividend rate and capital gain rate are the same. This change creates planning opportunities for investors and for certain businesses. The reduced rate is only temporary, so start planning now. Appreciating Investments An investment that increases in value while paying no income to you won't be taxed until you sell. By timing that sale carefully, you can enhance your tax and financial position considerably. For instance, you can wait to sell the investment until a year in which your tax rate is low. Or, you can give the investment to your children older than 18, who may sell it and be taxed at their lower rate. (Be sure to consider any potential gift tax implications.) If the value of your gross estate is less than $2.0 million in 2007, or you plan to use the estate tax marital deduction, consider keeping the investment, since it will pass to your beneficiaries tax free at your death. Your spouse and other heirs may also benefit from a step-up in the investment's basis to its fair market value at the date of your death. (If death occurs after 2009, basis step-up opportunities may be limited.) When deciding whether to buy or sell, consider the costs associated with an appreciating investment, including brokers' fees, closing costs, and property taxes, as well as the realistic potential for appreciation. Mutual Funds There are many reasons why mutual funds have become such a common investment vehicle. First of all, investors get the benefit of a professional fund manager making the investment decisions; mutual funds are a relatively inexpensive way to get the investing job done; funds satisfy the need for diversification; and they don't discriminate against the small investor. But, as easy as they make investing, deciding when to get in or out of a mutual fund is a bit more challenging. Funds usually make capital gain distributions in November or December. If you buy into a fund before the distribution date, you'll be taxed on the gains that are distributed even though they have already been reflected in your purchase price for the shares. Consider waiting until January to buy into the fund. Although you don't have control over the timing of sales inside of a mutual fund, you can look for mutual funds that consider certain tax-saving strategies. Some funds trade actively while others employ more of a buy-and-hold strategy. When comparing two funds with similar performance, consider the one with the lower turnover ratio. This fund will generally have fewer capital gain distributions. A high turnover ratio doesn't necessarily mean higher taxes. Many investors fail to keep accurate records, causing them to pay more taxes than necessary when they sell their fund shares. To calculate exact gains or losses on mutual fund investments, save every statement you receive. Determining which shares are sold can reduce your gain, or at least qualify it as long-term, and subject it to lower taxes. You also need to consider everything that makes up your basis, including: Fees or commissions paid when you bought the shares, Reinvested dividends, and Nontaxable returns of capital. Delay late-year mutual fund investments until after the fund's dividend date Bonds Instead of borrowing money from a bank, a company or municipality may elect to sell bonds to investors to help raise capital. The interest on tax-exempt bonds (those issued by a municipality) is usually not taxed at the federal level, but it may be subject to the AMT or cause Social Security benefits to be taxed. Typically, states don't tax bonds issued within their borders, but they often tax bond earnings from other states. Companies issue taxable bonds, which come in a number of varieties and corresponding risk/returns. Zero-coupon bonds are sold at a price far below their face value. They pay no cash interest, but reinvest earnings, which compound until the bonds mature. At maturity, they are redeemed at face value. Earnings are taxed each year, even though the investor receives no cash. However, bonds purchased through a tax-exempt Keogh or IRA aren't taxed until the funds are withdrawn. If you may be subject to the AMT this year, don't invest in tax-exempt bonds that generate interest income subject to the AMT. US Savings Bonds US savings bonds are an extremely low-risk investment, completely exempt from state taxation. Savings bonds sell for less than their face value and may be redeemed at fixed intervals for fixed amounts. The increase in value over the purchase price is reported as interest income on your tax return, either each year or at redemption. If you redeem Series EE bonds purchased after 1989 in your own name to pay for an immediate family member's college expenses, you may be able to exclude the interest altogether from your taxable income. This benefit is phased out as income levels increase. To see if your income level qualifies, click here. "I" bonds offer inflation protection. The interest paid on the bonds has two components: a fixed rate and a twice-yearly inflation adjustment based on the consumer price index. Like regular savings bonds, the interest income can be deferred until redemption. For more information, go to www.savingsbonds.gov.RT! Alert! If you've been holding onto a US savings bond for a long time, take note… Series E bonds issued in or after December 1965 only earn interest for 30 years. Bonds issued earlier pay interest for 40 years. This means that your bonds may no longer be paying interest! Check the issue date of your US savings bonds. If you're holding any noninterest bearing bonds, cash them in now! Wash Sales One investing trick that can help investors accelerate losses without significantly changing their investment position is to sell securities at a loss and then replace them with the same or similar securities. However, you must be aware of the rules on "wash sales." In general, you cannot buy the equivalent stock within 30 days before or 30 days after you sell your stock and deduct the loss. What you can do is sell the stock on which you have a paper loss to receive the loss this year, and then replace those stock shares with stock from another company in the same industry having similar prospects. Or, "double up" on the stock and sell your original shares 31 days later at a loss. Note that these wash sale restrictions do not apply to stocks sold at a gain. If you have accumulated capital losses (either from the current year or carried over), consider selling stock with built-in gain to offset these losses. You can then immediately repurchase the stock, essentially sheltering some of your gains without changing the makeup of your portfolio. Real Estate Rental Losses For The Pros Real estate professionals can deduct some rental real estate losses that other investors might lose. Generally, you are considered a real estate professional if you (or your spouse if you file jointly) spend more than half your business time dealing with real estate. This can include time spent on rental properties. Keep good records of your time and expenses. Low-Income Housing Credit If you are a real estate investor or builder, you can reduce your tax bill with the low- income housing tax credit. This annual credit amounts to about 9% of your qualified new low-income housing construction costs. The credit is granted for 10 consecutive years. Some or all of it can be taken against tax on any type of income, and the unused credit can be carried forward or carried back. For federally subsidized construction, and even for acquisition of existing housing, there is a similar credit of about 4%. The credits cannot be used to reduce your taxes below the AMT level. Like-Kind Exchanges Some people who own real estate for investment purposes are reluctant to sell the property, because they will most likely incur a large income tax liability on the gain realized. However, the property can be exchanged and the gain postponed (but not eliminated) under the like-kind exchange rules. To qualify as a like-kind exchange, the property received must also be real estate (land and/or buildings) intended for investment purposes or to produce income. To defer gain on a like-kind exchange, you must identify one or more parcels of like property within 45 days and complete the exchange within 180 days after you relinquish your property or by the due date of your tax return (including extensions), if earlier. If you receive anything in addition to the property, such as cash, or if you are relieved of any liabilities, you must recognize the gain up to the value of this additional amount received. Any gain you defer reduces the basis of the replacement property by that amount. While you don't have to recognize the gain, you also cannot recognize any loss if you do not do so. The like-kind exchange rules can also be used for property which is not real estate, such as equipment or vehicle trade-ins. However, check your tax basis before trading in a business car. Cars subject to the depreciation limits for luxury autos may have a remaining tax basis greater than fair market value, and would generate a loss. Consider a like-kind exchange to defer gain on the sale of business or investment property. However, don't use loss property in a like-kind exchange transaction. Instead, sell the old property outright, deduct the loss, and purchase the replacement property. Investing in Small Businesses Stock in certain industries that is issued after August 10, 1993, and held for at least 5 years gets special tax treatment. Half of your gain from the sale of the stock can be excluded from your taxable income. Although subject to a 28% gain rate, the exclusion will make your maximum effective rate 14% or less. However, part of the gain will be subject to AMT. You may also defer gain on the sale of publicly traded stock if you reinvest in a "specialized small business investment company." Normally, your individual deduction for net capital losses cannot exceed $3,000 each year. However, Section 1244 stock, a category created to encourage investment in small businesses, allows investors to deduct ordinary losses up to $50,000 per individual or $100,000 for a joint return. The stock of most new businesses with no more than $1 million of initial capitalization will be accorded Section 1244 status. However, only the original owners of Section 1244 stock qualify to receive ordinary loss treatment. Check with us to determine if your small business losses qualify for ordinary loss treatment. Tax Strategies For The Investor Check your gain or loss status before the end of the year. Recognize any capital losses so they can offset capital gains and up to $3,000 of ordinary income. You don't want to end up with losses which you can't use this year. If you have more losses than gains, consider selling gain property to offset those losses. If you are eligible to exercise stock options, consider whether you should postpone the exercise for a year or more. You may be able to take advantage of the tax rate decreases. Consider a like-kind exchange to defer gain on the sale of business or investment property. Delay late-year mutual fund investments until after the fund's dividend date. To calculate exact gains or losses on mutual fund investments, save every statement you receive. Remember that reinvested dividends increase your tax basis. Avoid investing in tax-exempt bonds if they generate interest subject to the AMT. When selling shares of stock that you purchased at different prices at different times, inform your broker beforehand that you are selling the shares with the highest basis. This will minimize taxable gain or maximize deductible loss. If you're an online trader, be aware that your service may not allow you to identify the shares you sell. Thus, you won't get the capital gains tax advantage of selling the high-basis shares. To avoid being taxed twice, count reinvested dividends as part of your tax basis when you sell stock. Share your next good investment opportunity with your children, even if you have to gift them the necessary capital to participate. They will pay the income tax on any gain recognized on the investment and the appreciation will be kept out of your estate.