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Tax-smart tactics
Consider all the consequences of your investment decisions
Savvy investors think about more than just picking the "right" investments; they focus on asset allocation and
diversification, considering the tax consequences of each transaction made along the way. There are many tax-smart tactics that can help you reach your goals.
Time capital gains and losses.
The 15% long-term capital gains rate — 20 percentage points lower than the highest regular income tax rate of 35% (see Chart 3) has been
extended through 2010. It applies only to investments held for more than 12 months. Remember this if you're considering purging your portfolio
of an underperforming stock. Holding on to it may help you cut your tax on the profit in half. Timing is also important if you've cashed
in some big gains during the year. Before year end, look for unrealized losses in your portfolio and sell them off, thus offsetting the gains.
If you end up with a net loss, you can claim up to $3,000 of the net capital loss against ordinary income this year and carry forward any
excess to future years.
Identify which shares you've sold.
Investors usually want to sell high-tax-basis shares when possible to reduce gain or increase the loss and offset other gains.
But if you bought the same security at different times and prices, you must identify which shares you've
sold when you file your tax return or you'll be deemed to have sold the shares on a first-in, first-out
(FIFO) basis. If you hold stock certificates, you must surrender the appropriate ones.
CHART 3:
2007 capital gains tax rates |
|
| Holding period |
Maximum
tax rate |
|
| 12 months or less (short term) |
35% |
|
| More than 12 months (long term) |
15% |
|
| Key long-term 15% rate exceptions: |
|
| Collectibles, such as artwork |
28% |
|
| Gain attributable to depreciation on real property |
25% |
|
Gain that would be taxed at 10% or 15%
based on the taxpayer's regular income tax rate |
5% |
|
| Data source: U.S. Internal Revenue Code |
Reduce turnover to save more tax dollars.
Selling stocks frequently or holding mutual funds with high turnover rates tends to repeatedly create capital gains. Holding stocks
long-term or choosing funds that provide primarily long-term gains can save you more tax dollars because of the lower long-term rates. But be
sure to consider overall performance, not just taxes, when selecting stocks 1or mutual funds.
Avoid wash sales.
The wash sale rule prevents you from taking a loss on a security if you buy a substantially identical security (or option to buy a
security) within 30 days before or after you sell it — you can recognize a loss only when you sell the replacement
security. Fortunately, there are ways around the wash sale rule. For example, you may buy securities of
a different company in the same industry or shares in a mutual fund that holds securities much like the ones you sold. Alternatively, consider
doubling up on your investment for a 31-day period before selling the original shares or selling and then waiting 31 days to repurchase.
Exercise stock options with care.
Before exercising (or postponing exercise of) options or selling stock purchased via an exercise, consider
the complicated tax rules that may substantially add to your tax liability if you act hastily — or minimize it
if you plan properly. At the same time, financial risks can be great if you focus solely on getting the
best tax treatment.
Consider an installment sale or like-kind exchange.
An installment sale allows you to defer capital gains on most assets other than publicly traded securities.
You can defer your overall tax burden by spreading the gain over several years as you receive the
proceeds. Warning: Depreciation recapture income is recognized in the year of sale, even if no cash
is received.
If you're selling investment or rental real estate, consider a like-kind exchange. You may be able to defer
paying tax on the gain over the time you hold the replacement property, though you'll reduce your depreciation
deductions on that property.
Weigh the tax impact of bonds.
Although interest on U.S. government obligations is taxable on your federal return, it's generally exempt on your
state and local returns. In contrast, interest on state and local government bonds is excludible on your
federal return. If the state or local bonds were issued in your home state, interest also may be excludible
on your state return. But corporate bond interest is fully taxable for federal and state purposes.
Swap your bonds.
With a bond swap, you sell a bond, take a capital loss and then immediately buy another bond of similar quality
from a different issuer. The wash sale rule (see "Avoid wash sales" on page 7) doesn't apply because
the bonds aren't considered substantially identical. Thus, you achieve a tax loss with virtually no change in
economic position.
Beware of OID income.
Bonds (except U.S. savings bonds) with original issue discount (OID) build up "interest" as they rise toward their
maturity price. The IRS says you earn a portion of that interest annually — even though the bonds don't pay
you this interest annually — and expects you to pay tax on it. So, these investments may be best
suited for tax-deferred vehicles, such as IRAs, or for investors with sufficient cash flow to absorb this tax.
Take the investment interest expense deduction.
You can deduct investment interest — up to your net investment income for the year — on any money you borrow to buy or carry
taxable investments. But you can't include long-term capital gains or qualified dividends in your net investment
income for investment interest deduction purposes without waiving the favorable 15% rate and subjecting
your gains or dividends to your higher ordinary income tax rate.
Tax Action Strategy:
CONSIDER DIVIDEND-PAYING STOCKS
With the extension of the lower 15% maximum federal tax rate on qualified
dividends through 2010, dividend-paying stocks continue to be desirable
to many investors. But beware of potential price increases as a result,
perhaps offsetting the tax advantage with an inflated price. Nevertheless,
the lower rate serves as a reminder that dividend-paying stocks may have
a place in your portfolio.
Download printable Tax Guides PDF >
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