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TAXATION

How Capital Gains from the Sale of a Home Are Taxed

For most of us, our home represents our largest asset. Over time, the management of this asset can make a big difference in our overall financial outlook. One of the largest planning opportunities home ownership brings is the favorable tax treatment afforded the sale of a primary residence.

The gain on the sale of a home is considered a gain on the sale of a capital asset. Any taxable profit you make is subject to a maximum long-term capital gain rate of 15% (down to 5% for taxpayers in the 10-15% federal income tax bracket) if you owned the house for more than 12 months. Gain on the sale of a home may be taxable only if they exceed $250,000 for single filers ($500,000 for joint filers) if certain conditions discussed below are met.

 

Determining Your Net Gain
To determine your profit (gain), you subtract your basis from the sale price minus all costs and commissions. For instance, if you sell a house for $250,000, and must pay your broker 6% of the sale price -- or $15,000 -- your sale price for determining capital gain tax is $235,000 ($250,000 minus $15,000).

Say you bought that house 20 years ago for $35,000. You have since redone the kitchen and bathrooms, put in new windows, added a bedroom, and a new roof. Your basis in the house is $35,000 plus the cost of all of the capital improvements you have made, providing you have documentation verifying the costs. Let's assume the total cost of those improvements over the 20 years you owned the home is $40,000. In such a case, your basis would be $75,000. Your capital gain would be $235,000 minus $75,000, or $160,000. If you are in the 28% federal tax bracket or higher, your capital gain tax on your home sale would be $24,000 unless you use the principal residence exclusion.

The Primary Residence Exclusion
Here's where the favorable tax treatment of capital gains from a residence come in. A $250,000 exclusion for single filers ($500,000 for joint filers) is now available to all taxpayers. You can claim the exclusion once every two years. To be eligible, you must have owned the residence and occupied it as a principal residence for at least two of the five years prior to the sale or exchange. If you fail to meet these requirements due to health reasons, a change in place of employment, or other unforeseen circumstances, you can exclude the fraction of the $250,000 ($500,000 if married filing a joint return) equal to the fraction of two years that these requirements are met. For example, let's say you were forced to move for employment reasons after only living in a home for 12 months. Without the qualified exclusion, your full tax would have been $20,000. Instead, you would pay just half, since you lived in the home 12 of the 24 months required, or 0.5 of the period. The tax of $20,000 multiplied by 0.5 would yield a tax bill of just $10,000.

For many Americans at or nearing retirement age, their home represents a terrific opportunity to "cash out," pad their retirement portfolio with tax-free gains, and help ensure their "golden years" truly live up to the name. Feel free to ask us for guidance in making this important decision.

  

Tax Issues with Capital Gains and Dividends

Under the Jobs and Growth Tax Relief Reconciliation Act of 2003, generating long-term capital gains or investing for dividend income could be two of your big opportunities to save on taxes. Be aware that the Act of 2003 created "sunset provisions," however, meaning that the tax rates on both capital gains and dividends may go up again unless congress acts to extend the rates. The lower rates are currently only legislated through 2008, although many observers believe these rates will eventually be made permanent.

 

Capital Gains
Rates: The maximum tax rate on net capital gains from assets held 12 months or more has been reduced to 15% (from 20%) for most taxpayers and reduced to 5% (from 10%) for taxpayers in the 10% and 15% tax rate brackets for property sold or otherwise disposed of after May 5, 2003 (and installment sale payments received after that date). The reduced rate applies for both the regular tax and the alternative minimum tax.

(Note: The higher rates that apply to unrecaptured section 1250 gain, collectibles gain, and section 1202 gain have not changed.)

Tax Treatment of Capital Losses: If you incur losses from the sale of a capital asset, you can deduct those losses to the extent they offset capital gains from the sale of other assets. If your losses exceed your gains, you can only deduct up to $3,000 ($1,500 if you are married and filing separately) of capital losses in a tax year against other income on Form 1040. You can carry losses forward and continue to deduct $3,000 ($1,500 if filing separately) annually against other income until your losses are used up.

Other Issues: A long-term gain generally applies to assets held for a minimum of one year or more. Short-term capital gains are considered as part of your Adjusted Gross Income (AGI) and taxed at your ordinary income tax rate. Investors must avoid "wash sales" (selling and repurchasing the same or virtually the same asset), and you should also be aware of potential Alternative Minimum Tax (AMT) implications of taking large capital gains.

 

Dividends
Changes Create Tax Savings Opportunities: In the past, dividend income was treated as just another source of ordinary income, and taxed at your normal tax rate. Now, the same 15% (or 5%) maximum tax rate that applies to net capital gain also applies to dividends paid by most domestic and foreign corporations after December 31, 2002.

For taxpayers in higher brackets, this represents a significant reduction. Certain dividends from regulated investment companies such as mutual funds, real estate investment trusts, and certain foreign corporations do not qualify for the reduced rates. There are also some holding requirements, consult your tax professional for more details.

As with capital gains, the Tax Relief Act of 2003 also created "sunset provisions" for dividend rates, so tax rates may go up again unless Congress acts to extend the rate reductions. The lower rates are currently only legislated through 2008. 

 


 

 

 

  

 

 

 

 


 

 


 

Gift Tax Basics

The federal government imposes a substantial tax on gifts of money or property above certain levels. Without such a tax, someone with a sizable estate could give away a large portion of their property before death and escape estate taxes altogether. For this reason, the gift tax acts more or less as a backstop to the estate tax. Yet few people actually pay a gift tax during their lifetime. A gift program can substantially reduce overall transfer taxes; however, it requires good planning and a commitment to proceed with the gifts.

 

Advantages of Gift Giving
You may have many reasons for making gifts - some people have personal motives, others are motivated by tax considerations. Many want their gift-giving program to meet both personal and tax-planning objectives. Reasons for considering a gift-giving plan include:

• Assisting someone in immediate financial need
• Providing financial security for the recipient
• Giving the recipient experience in handling money
• Seeing the recipient enjoy the gift
• Taking advantage of the annual exclusion
• Paying a gift tax now to reduce overall taxes
• Giving tax-advantaged gifts to minors

 

Gift Tax Annual Exclusion
Perhaps the easiest way to reduce the size of your taxable estate is to make regular use of the gift tax annual exclusion. You may give up to $12,000 each year to as many persons as you want without incurring any gift tax. (Congress has now indexed this gift level to inflation; however, the figure will rise only in increments of $1,000.) If your spouse joins in making the gift (by consenting on a gift tax return), you may (as a couple) give $24,000 to each person annually without any gift tax liability.

Unlimited Gift Tax Exclusion
In addition to the $12,000 exclusion, there is an unlimited gift tax exclusion available to pay someone's medical or educational expenses. The beneficiary does not have to be your dependent or even related to you, although payment of a grandchild's expenses is a common use of the exclusion. You must make the payment directly to the institution providing the service -- the beneficiary himself or herself must not receive the payment.

 

Gift Programs and Your Estate
Use of the gift tax exclusion in a single year may not affect your estate tax situation significantly, but you can reduce your taxable estate substantially through a planned annual program of $12,000 gifts ($24,000 if you are married). All gifts within the exclusion limits are protected from federal estate taxes.

In addition to reducing the size of your estate, another major tax advantage of making a gift is the removal of future appreciation in the property's value from your estate. Suppose that you give stocks worth $50,000 to your children now. If you die in 10 years and the stock is worth $130,000, your estate will escape tax on the $80,000 appreciation even though you pay a gift tax on your next tax return.

To learn more about gifting strategies and how they can play a role in your tax and estate planning, contact us to schedule a consultation. We'll be happy to help.

 

Home Work: Deducting Your Home Office

With the rise of cell phones and the Internet - not to mention a growing fluidity to employment situations - more Americans are choosing to telecommute and work from home.

The tax deduction for home-office expenses is among the most misunderstood and misused (if not unused) tax questions faced by those who work from home. One of the enduring myths is that the deduction is a good way to trigger an IRS audit. This article seeks to clarify the deduction and put those fears to rest for whom the home-office tax deduction is a legitimate business expense.

 

When Can Home Office Expenses Be Deducted?
The costs associated with maintaining a home office can be deducted only if strict IRS guidelines are met - generally that the office is used exclusively for business purposes. A spare bedroom where your mother-in-law stays while visiting from out of town, a corner of your downstairs family room, the nook in your master bedroom ... these types of home-office spaces rarely qualify under IRS rules.

The Taxpayer Relief Act of 1997 has eased the requirements for determining if the costs associated with a home office can be deducted. The new law states that a home office qualifies as a "principal place of business" if (1) the taxpayer uses the office to conduct administrative or management activities of a trade or business and (2) there is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities of the trade or business.

Deductions will continue to be allowed for a home office meeting the above two-part test only if the taxpayer uses the office exclusively on a regular basis as a place of business and, in the case of an employee, only if such exclusive use is for the employer's convenience.

 

Home Office Deduction Limits
The home office deduction is limited to the gross income from the activity, reduced by expenses that would otherwise be deductible (such as mortgage interest and taxes) and all other expenses related to the activities that are not house-related. A deduction isn't allowed to the extent that it creates or increases a net loss from the activity. Any disallowed deduction may be carried over to future years.

As part of its stated mission to be "kinder and gentler" to taxpayers, the IRS has eased guidelines somewhat on those taking deductions for their home offices. However, it's a good idea to solicit the advice of a knowledgeable professional to ensure you meet all the requirements before taking this deduction. We can help.

 

Tax Benefits of Home Ownership

In tax lingo, your principal residence is the place where you legally reside. It's typically the place where you spend most of your time, but several other factors are also relevant in determining your principal residence. Many of the tax benefits associated with home ownership apply mainly to your principal residence--different rules apply to second homes and investment properties. Here's what you need to know to make owning a home really pay off at tax time.

 

Deducting mortgage interest
One of the most important tax benefits that comes with owning a home is the fact that you may be able to deduct any mortgage interest that you pay. If you itemize deductions on Schedule A of your federal income tax return, you can generally deduct the interest that you pay on debt resulting from a loan used to buy, build, or improve your home, provided that the loan is secured by your home. In tax terms, this is referred to as "home acquisition debt." You're able to deduct home acquisition debt on a second home as well as your main home (note, however, that when it comes to second homes, special rules apply if you rent the home out for part of the year).

Up to $1 million of home acquisition debt ($500,000 if you're married and file separately) qualifies for the interest deduction. (Different rules apply if you incurred the debt before October 14, 1987.) If your mortgage loan exceeds $1 million, some of the interest that you pay on the loan may not be deductible.

You're also generally able to deduct interest you pay on certain home equity loans or lines of credit secured by your home, but the rules are different. Home equity debt typically involves a loan secured by your main or second home, not used to buy, build, or improve your home. Deductible home equity debt is limited to the lesser of:

· The fair market value of the home minus the total home acquisition debt on that home, or
· $100,000 (or $50,000 if your filing status is married filing separately) for main and second homes combined

The interest that you pay on a qualifying home equity loan or line of credit is generally deductible regardless of how you use the loan proceeds. For more information, see IRS Publication 936.

 

Mortgage insurance
For 2011, you can treat qualified mortgage insurance as home mortgage interest, provided that the insurance is associated with home acquisition debt, and is being paid on an insurance contract issued after 2006. Qualified mortgage insurance is mortgage insurance provided by the Department of Veterans Affairs, the Federal Housing Administration, the Rural Housing Service, and qualified private mortgage insurance (PMI) providers. The deduction is phased out, though, if your adjusted gross income is more than $100,000 ($50,000 if you're married and file separately).

 

Deducting real estate property taxes
If you itemize deductions on Schedule A, you can also generally deduct real estate taxes that you've paid on your property in the year that they're paid to the taxing authority. If you pay your real estate taxes through an escrow account, you can only deduct the real estate taxes actually paid by your lender from the escrow account during the year. Only the legal property owner can deduct real estate taxes. You cannot deduct homeowner association assessments, since they are not imposed by a state or local government.

 

AMT considerations
If you're subject to the alternative minimum tax (AMT) in a given year, your ability to deduct mortgage interest and real estate taxes may be limited. That's because, under the AMT calculation, no deduction is allowed for state and local taxes, including real estate tax. And, under the AMT rules, only interest on mortgage and home equity debt used to buy, build, or improve your home is deductible. So, if you use a home equity loan to purchase a car, the interest on the loan may be deductible for regular income tax purposes, but not for AMT.

 

Deducting points and closing costs
Buying a home is confusing enough without wondering how to handle the settlement charges at tax time. When you take out a loan to buy a home, or when you refinance an existing loan on your home, you'll probably be charged closing costs. These may include points, as well as attorney's fees, recording fees, title search fees, appraisal fees, and loan or document preparation and processing fees. You'll need to know whether you can deduct these fees (in part or in full) on your federal income tax return, or whether they're simply added to the cost basis of your home.

Before we get to that, let's define one term. Points are certain charges paid when you obtain a home mortgage. They are sometimes called loan origination fees. One point typically equals one percent of the loan amount borrowed. When you buy your main home, you may be able to deduct points in full in the year that you pay them if you itemize deductions and meet certain requirements. You may even be able to deduct points that the seller pays for you. More information about these requirements is available in IRS Publication 936.

Refinanced loans are treated differently. Generally, points that you pay on a refinanced loan are not deductible in full in the year that you pay them. Instead, they're deducted ratably over the life of the loan. In other words, you can deduct a certain portion of the points each year. If the loan is used to make improvements to your principal residence, however, you may be able to deduct the points in full in the year paid.

What about other settlement fees and closing costs? Generally, you cannot deduct these costs on your tax return. Instead, you must adjust your tax basis (the cost, plus or minus certain factors) in your home. For example, you'd increase your basis to reflect certain closing costs, including:

· Abstract fees
· Charges for installing utility services
· Legal fees
· Recording fees
· Surveys
· Transfer or stamp taxes
· Owner's title insurance

For more information, see IRS Publication 530.

 

Tax treatment of home improvements and repairs
Home improvements and repairs are generally nondeductible. Improvements, though, can increase the tax basis of your home (which in turn can lower your tax bite when you sell your home). Improvements add value to your home, prolong its life, or adapt it to a new use. For example, the installation of a deck, a built-in swimming pool, or a second bathroom would be considered an improvement. In contrast, a repair simply keeps your home in good operating condition. Regular repairs and maintenance (e.g., repainting your house and fixing your gutters) are not considered improvements and are not included in the tax basis of your home. However, if repairs are performed as part of an extensive remodeling of your home, the entire job may be considered an improvement.

If you make certain improvements to your home that improve your home's energy efficiency, you may be eligible for a federal income tax credit.

 

Energy tax credit
A credit is available to individuals who make energy-efficient improvements to their homes. You may be entitled to a 10% credit for the purchase of qualified energy-efficient improvements including a roof, windows, skylights, exterior doors, and insulation materials. Specific credit amounts may also be available for the purchase of specified energy-efficient property: $50 for an advanced main air circulating fan; $150 for a qualified furnace or hot water boiler; and $300 for other items, including qualified electric heat pump water heaters and central air conditioning units.

There's a lifetime credit cap of $500 ($200 for windows), however. So, if you've claimed the credit in the past--in one or more tax years after 2005--you're only entitled to the difference between the current cap, and the total amount that you've claimed in the past. That includes any credit that you claimed in 2009 and 2010, when the aggregate limit on the credit was $1,500.

Exclusion of capital gain when your house is sold
If you sell your principal residence at a loss, you generally can't deduct the loss on your tax return. If you sell your principal residence at a gain you may be able to exclude some or all of the gain from federal income tax.

Generally speaking, capital gain (or loss) on the sale of your principal residence equals the sale price of your home less your adjusted basis in the property. Your adjusted basis is the cost of the property (i.e., what you paid for it initially), plus amounts paid for capital improvements, less any depreciation and casualty losses claimed for tax purposes.

If you meet all requirements, you can exclude from federal income tax up to $250,000 ($500,000 if you're married and file a joint return) of any capital gain that results from the sale of your principal residence. In general this exclusion can be used only once every two years. To qualify for the exclusion, you must have owned and used the home as your principal residence for a total of two out of the five years before the sale.

For example, you and your spouse bought your home in 1981 for $200,000. You've lived in it ever since and file joint federal income tax returns. You sold the house yesterday for $350,000. Your entire $150,000 gain ($350,000 - $200,000) is excludable. That means that you don't have to report your home sale on your federal income tax return.

What if you fail to meet the two-out-of-five-year rule? Or what if you used the capital gain exclusion within the past two years with respect to a different principal residence? You may still be able to exclude part of your gain if your home sale was due to a change in place of employment, health reasons, or certain other unforeseen circumstances. In such a case, exclusion of the gain may be prorated.

 

Additionally, special rules may apply in the following cases:

· If your principal residence contained a home office or was otherwise used partially for business purposes
· If you sell vacant land adjacent to your principal residence
· If your principal residence is owned by a trust
· If you rented part of your principal residence to tenants, or used it as a vacation or second home
· If you owned your principal residence jointly with an unmarried individual

Note: Members of the uniformed services, foreign services, and intelligence community, as well as certain Peace Corps volunteers and employees may elect to suspend the running of the two-out-of-five-year requirement during any period of qualified official extended duty up to a maximum of ten years.

Consult a tax professional for details.

Updated 12/7/2011

Tax-Deferred Annuities: Are They Right for You?

Tax-deferred annuities can be a valuable tool, particularly for retirement savings. However, they are not appropriate for everyone.

 

Five questions to consider
Think about each of the following questions. If you can answer yes to all of them, an annuity may be a good choice for you.

1. Are you making the maximum allowable pretax contribution to employer-sponsored retirement plans (a 401(k) or 403(b) plan through your employer, or a Keogh plan or SEP-IRA if you are self-employed), or to a deductible traditional IRA? These are tax-advantaged vehicles that should be fully utilized before you contribute to an annuity.

2. Are you making the maximum allowable contribution to a Roth IRA, Roth 401(k), or Roth 403(b), which provide additional tax benefits not available in a nonqualified annuity?

3. Will you need more retirement income than your current retirement plan(s) will provide? If you begin making the maximum allowable contributions to both a qualified plan and an IRA in your 30s or early 40s, you may have enough retirement income without an annuity.

4. Are you sure you won't need the money until at least age 59½? Withdrawals from an annuity made before this age are usually subject to a 10 percent early withdrawal penalty tax on earnings levied by the IRS.

5. Will you take distributions from your annuity on an ongoing basis throughout your retirement? You typically have the option of making a lump-sum withdrawal from an annuity, but this is almost always a bad idea. If you do, you'll have to pay taxes on all of the earnings that have built up over the years. If you take gradual distributions, you pay taxes a little at a time, allowing the rest of the money to continue growing tax deferred. In addition, if the annuity is nonqualified and you elect to receive an annuity payout, you will enjoy an exclusion allowance on each payment, in which a portion of each payment is considered a return of principal and is not taxable.

Note: Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk including the possibility of loss of principal. Variable annuities contain fees and charges including, but not limited to mortality and expense risk charges, sales and surrender (early withdrawal) charges, administrative fees and charges for optional benefits and riders. Variable annuities are sold by prospectus. You should consider the investment objectives, risk, charges and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity, can be obtained from the insurance company issuing the variable annuity, or from your financial professional. You should read the prospectus carefully before you invest.

Updated 12/7/2011

 

Tax Planning for Annuities

Favorable tax treatment is one of the main reasons for buying an annuity. But what exactly are the tax benefits? And are there any drawbacks? It's important to know the answers to these questions before deciding whether to purchase an annuity.

Of course, any information pertaining to taxes is complex, full of exceptions, and subject to change. This discussion deals with the general rules for taxation of annuities--you should consult a tax advisor for more specific information before you take any action.

 

Taxation of premiums
Annuities are typically funded with after-tax dollars. So, the money you pay into an annuity (in the form of premiums) is nondeductible. By placing funds in an annuity, you will not realize any current income tax savings, unlike putting money into a traditional IRA, 401(k) plan, or other employer-sponsored retirement plan.

 

Tax-deferred growth
Unlike most investments, an increase in the value of an annuity from interest is not currently taxable. Generally, annuity funds are allowed to grow tax deferred until they're distributed, at which time the owner will pay ordinary income tax on all gains.

 

Taxation of premature withdrawals
Withdrawals taken before age 59½ may be subject to a 10 percent IRS penalty tax unless an exception applies. When you make a withdrawal from an annuity, the IRS assumes that earnings are withdrawn first. The 10 percent penalty applies to the earnings portion of a withdrawal. So, early withdrawals are costly from a tax standpoint.

For example, if your annuity has grown by $1,000 since you purchased it, a $500 withdrawal would be considered 100 percent interest and would be subject to the 10 percent penalty--in this case, $50. In addition, because the entire withdrawal represents earnings, it would be subject to ordinary income tax. If you are in the 25 percent tax bracket, your income tax liability on the withdrawal would be $125. Adding this to the early withdrawal penalty, $175 of your $500 withdrawal would end up in the IRS's pocket.

 

Taxation of scheduled distributions
If you choose an annuitization option, you will begin receiving regular distributions from your annuity over a predetermined period of time. Each distribution consists of two components: principal (a return of the money you paid into the annuity) and earnings. The percentages of principal and earnings of each distribution will depend on the annuitization option chosen. Again, the earnings portion of each distribution will be treated as ordinary income. Also, depending on the annuitization option chosen, the 10 percent penalty rule may not apply.

Note: Annuity guarantees are subject to the claims-paying ability of the annuity issuer.

Note: Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk including the possibility of loss of principal. Variable annuities contain fees and charges including, but not limited to mortality and expense risk charges, sales and surrender (early withdrawal) charges, administrative fees and charges for optional benefits and riders. Variable annuities are sold by prospectus. You should consider the investment objectives, risk, charges and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity, can be obtained from the insurance company issuing the variable annuity, or from your financial professional. You should read the prospectus carefully before you invest.

 

Taxation of lump-sum distributions
Taking a lump-sum distribution of your annuity funds can have many consequences. If you make this election within the first few years after purchasing your annuity, you may be subject to surrender charges imposed by the issuer. In any case, the earnings portion of the distribution will be treated as ordinary income in the year you take the distribution. Also, keep in mind that a large lump-sum distribution could actually push you into a higher tax bracket, dramatically increasing your tax liability.

Updated 12/7/2011

 

Tax Planning for Income

The goal of income tax planning is to minimize your federal income tax liability. You can achieve this in different ways. Typically, though, you'd look at ways to reduce your taxable income, perhaps by deferring your income or shifting income to family members. You should also consider deduction planning, investment tax planning, and year-end planning strategies to lower your overall income tax burden.

 

Postpone your income to minimize your current income tax liability
By deferring (postponing) income to a later year, you may be able to minimize your current income tax liability and invest the money that you'd otherwise use to pay income taxes. And when you eventually report the income, you may be in a lower income tax bracket.

Certain retirement plans can help you to postpone the payment of taxes on your earned income. With a 401(k) plan, for example, you contribute part of your salary into the plan, paying income tax only when you withdraw money from the plan (withdrawals before age 59½ may be subject to a 10 percent penalty). This allows you to postpone the taxation of part of your salary and take advantage of the tax-deferred growth in your investment earnings.

There are many other ways to postpone your taxable income. For instance, you can contribute to a traditional IRA, buy permanent life insurance (the cash value part grows tax deferred), or invest in certain savings bonds. You may want to speak with a tax professional about your tax planning options.

 

Shift income to your family members to lower the overall family tax burden
You can also minimize your federal income taxes by shifting income to family members who are in a lower tax bracket. For example, if you own stock that produces a great deal of dividend income, consider gifting the stock to your children. After you've made the gift, the dividends will represent income to them rather than to you. This may lower your tax burden. Keep in mind that you can make a tax-free gift of up to $13,000 per year per recipient without incurring federal gift tax.

However, look out for the kiddie tax rules. Under these rules, for children (1) under age 18, or (2) under age 19 or full-time students under age 24 who don't earn more than one-half of their financial support, any unearned income over $1,900 is taxed at the parent's marginal tax rate. Also, be sure to check the laws of your state before giving securities to minors.

Other ways of shifting income include hiring a family member for the family business and creating a family limited partnership. Investigate all of your options before making a decision.

 

Deduction planning involves proper timing and control over your income
Lowering your federal income tax liability through deductions is the goal of deduction planning. You should take all deductions to which you are entitled, and time them in the most efficient manner.

As a starting point, you'll have to decide whether to itemize your deductions or take the standard deduction. Generally, you'll choose whichever method lowers your taxes the most. If you itemize, be aware that some of your deductions may be disallowed if your adjusted gross income (AGI) reaches a certain threshold figure. If you expect that your AGI might limit your itemized deductions, try to lower your AGI. To lower your AGI for the year, you can defer part of your income to next year, buy investments that generate tax-exempt income, and contribute as much as you can to qualified retirement plans.

Because you can sometimes control whether a deductible expense falls into the current tax year or the next, you may have some control over the timing of your deduction. If you're in a higher federal income tax bracket this year than you expect to be in next year, you'll want to accelerate your deductions into the current year. You can accelerate deductions by paying deductible expenses and making charitable contributions this year instead of waiting until next.

 

Investment tax planning uses timing strategies and focuses on your after-tax return
Investment tax planning seeks to minimize your overall income tax burden through tax-conscious investment choices. Several potential strategies may be considered. These include the possible use of tax-exempt securities and intentionally timing the sale of capital assets for maximum tax benefit.

Although income is generally taxable, certain investments generate income that's exempt from tax at the federal or state level. For example, if you meet specific requirements and income limits, the interest on certain Series EE bonds (these may also be called Patriot bonds) used for education may be exempt from federal, state, and local income taxes. Also, you can exclude the interest on certain municipal bonds from your federal income (tax-exempt status applies to income generated from the bond; a capital gain or loss realized on the sale of a municipal bond is treated like gain or loss from any other bond for federal tax purposes). And if you earn interest on tax-exempt bonds issued in your home state, the interest will generally be exempt from state and local tax as well. Keep in mind that although the interest on municipal bonds is generally tax exempt, certain municipal bond income may be subject to the federal alternative minimum tax. When comparing taxable and tax-exempt investment options, you'll want to focus on those choices that maximize your after-tax return.

In most cases, long-term capital gain tax rates are lower than ordinary income tax rates. That means that the amount of time you hold an asset before selling it can make a big tax difference. Since long-term capital gain rates generally apply when an asset has been held for more than a year, you may find it makes good tax-sense to hold off a little longer on selling an asset that you've held for only 11 months. Timing the sale of a capital asset (such as stock) can help in other ways as well. For example, if you expect to be in a lower income tax bracket next year, you might consider waiting until then to sell your stock. You might want to accelerate income into this year by selling assets, though, if you have capital losses this year that you can use to offset the resulting gain.

Note:You should not decide which investment options are appropriate for you based on tax considerations alone. Nor should you decide when (or if) to sell an asset solely based on the tax consequence. A financial or tax professional can help you decide what choices are right for your specific situation.

 

Year-end planning focuses on your marginal income tax bracket
Year-end tax planning, as you might expect, typically takes place in October, November, and December. At its most basic level, year-end tax planning generally looks at ways to time income and deductions to give you the best possible tax result. This may mean trying to postpone income to the following year (thus postponing the payment of tax on that income) and accelerate deductions into the current year. For example, assume it's December and you know that you're in a higher tax bracket this year than you will be in next year. If you're able to postpone the receipt of income until the following year, you may be able to pay less overall tax on that income. Similarly, if you have major dental work scheduled for the beginning of next year, you might consider trying to reschedule for December to take advantage of the deduction this year. The right year-end tax planning moves for you will depend on your individual circumstances.

Updated 12/7/2011

 

Taxation of Investments

It's nice to own stocks, bonds, and other investments. Nice, that is, until it's time to fill out your federal income tax return. At that point, you may be left scratching your head. Just how do you report your investments and how are they taxed?

 

Is it ordinary income or a capital gain?
To determine how an investment vehicle is taxed in a given year, first ask yourself what went on with the investment that year. Did it generate income, such as interest? If so, the income is probably considered ordinary. Did you sell the investment? If so, a capital gain or loss is probably involved. (Certain investments can generate both ordinary income and capital gain income, but we won't get into that here.)

If you receive dividend income, it may be taxed either at ordinary income tax rates or at the rates that apply to long-term capital gain income. Currently, dividends paid to an individual shareholder from a domestic corporation or qualified foreign corporation are generally taxed at the same rates that apply to long-term capital gains. These rates are 15 percent for an individual in a marginal tax rate bracket that is greater than 15 percent, or 0 percent for an individual in the 10 or 15 percent marginal tax rate bracket. But special rules and exclusions apply, and some dividends (such as those from money market mutual funds) continue to be treated as ordinary income.

The distinction between ordinary income and capital gain income is important because different tax rates may apply and different reporting procedures may be involved. Here are some of the things you need to know.

 

Categorizing your ordinary income
Investments often produce ordinary income. Examples of ordinary income include interest and rent. Many investments--including savings accounts, certificates of deposit, money market accounts, annuities, bonds, and some preferred stock--can generate ordinary income. Ordinary income is taxed at ordinary (as opposed to capital gains) tax rates.

But not all ordinary income is taxable--and even if it is taxable, it may not be taxed immediately. If you receive ordinary income, the income can be categorized as taxable, tax exempt, or tax deferred.

· Taxable income: This is income that's not tax exempt or tax deferred. If you receive ordinary taxable income from your investments, you'll report it on your federal income tax return. In some cases, you may have to detail your investments and income on Schedule B.
· Tax-exempt income: This is income that's free from federal and/or state income tax, depending on the type of investment vehicle and the state of issue. Municipal bonds and U.S. securities are typical examples of investments that can generate tax-exempt income.
· Tax-deferred income: This is income whose taxation is postponed until some point in the future. For example, with a 401(k) retirement plan, earnings are reinvested and taxed only when you take money out of the plan. The income earned in the 401(k) plan is tax deferred.

A quick word about ordinary losses: It's possible for an investment to generate an ordinary loss, rather than ordinary income. In general, ordinary losses reduce ordinary income.

 

Understanding what basis means
Let's move on to what happens when you sell an investment vehicle. Before getting into capital gains and losses, though, you need to understand an important term--basis. Generally speaking, basis refers to the amount of your investment in an asset. To calculate the capital gain or loss when you sell or exchange an asset, you must know how to determine both your initial basis and adjusted basis in the asset.

First, initial basis. Usually, your initial basis equals your cost--what you paid for the asset. For example, if you purchased one share of stock for $10,000, your initial basis in the stock is $10,000. However, your initial basis can differ from the cost if you did not purchase an asset but rather received it as a gift or inheritance, or in a tax-free exchange.

Next, adjusted basis. Your initial basis in an asset can increase or decrease over time in certain circumstances. For example, if you buy a house for $100,000, your initial basis in the house will be $100,000. If you later improve your home by installing a $5,000 deck, your adjusted basis in the house may be $105,000. You should be aware of which items increase the basis of your asset, and which items decrease the basis of your asset. See IRS Publication 551 for details.

 

Calculating your capital gain or loss
If you sell stocks, bonds, or other capital assets, you'll end up with a capital gain or loss. Special capital gains tax rates may apply. These rates may be lower than ordinary income tax rates.

Basically, capital gain (or loss) equals the amount that you realize on the sale of your asset (i.e., the amount of cash and/or the value of any property you receive) less your adjusted basis in the asset. If you sell an asset for more than your adjusted basis in the asset, you'll have a capital gain. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $15,000, your capital gain will be $5,000. If you sell an asset for less than your adjusted basis in the asset, you'll have a capital loss. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $8,000, your capital loss will be $2,000.

Schedule D of your income tax return is where you'll calculate your short-term and long-term capital gains and losses, and figure the tax due, if any. You'll need to know not only your adjusted basis and the amount realized from each sale, but also your holding period, your marginal income tax bracket, and the type of asset(s) involved. See IRS Publication 544 for details.

· Holding period: Generally, the holding period refers to how long you owned an asset. A capital gain is classified as short term if the asset was held for a year or less, and long term if the asset was held for more than one year. The tax rates applied to long-term capital gain income are generally lower than those applied to short-term capital gain income. Short-term capital gains are taxed at the same rate as your ordinary income.
· Marginal income tax bracket: Marginal income tax brackets are expressed by their marginal tax rate (e.g., 15 percent, 25 percent). Your marginal tax bracket depends on your filing status and the level of your taxable income. When you sell an asset, the capital gains tax rate that applies to the gain will depend on your marginal income tax bracket. Generally, a 0 percent long-term capital gains tax rate applies to individuals in the 10 or 15 percent tax bracket, while the long-term capital gains of individuals in the other tax brackets are currently subject to a maximum rate of 15 percent.

Type of asset: The type of asset that you sell will dictate the capital gain rate that applies, and possibly the steps that you should take to calculate the capital gain (or loss). For instance, the sale of an antique is taxed at the maximum tax rate of 28 percent even if you held the antique for more than 12 months.

 

Using capital losses to reduce your tax liability
You can use capital losses from one investment to reduce the capital gains from other investments. You can also use a capital loss against up to $3,000 of ordinary income this year ($1,500 for married persons filing separately). Losses not used this year can offset future capital gains. Schedule D of your federal income tax return can lead you through this process.

 

Getting help when things get too complicated
The sale of some assets are more difficult to calculate and report than others, so you may need to consult an IRS publication or other tax references to properly calculate your capital gain or loss. Also, remember that you can always seek the assistance of an accountant or other tax professional.

 

Starting in 2013 -- new Medicare contribution tax on unearned income may apply
Beginning in 2013, high-income individuals may be subject to a new 3.8 percent Medicare contribution tax on unearned income (the new tax is also imposed on estates and trusts, although slightly different rules apply). The tax is equal to 3.8 percent of the lesser of:

· Your net investment income (generally, net income from interest, dividends, annuities, royalties and rents, and capital gains, as well as income from a business that is considered a passive activity), or
· The amount of your modified adjusted gross income that exceeds $200,000 ($250,000 if married filing a joint federal income tax return, $125,000 if married filing a separate return)

So, effectively, you're subject to the additional 3.8 percent tax only if your adjusted gross income exceeds the dollar thresholds listed above. It's worth noting that interest on tax-exempt bonds is not considered net investment income for purposes of the additional tax. Qualified retirement plan and IRA distributions are also not considered investment income.

Updated 12/7/2011 

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