Understanding Capital Gains Tax

To understand the capital gains tax, we must begin by understanding exactly what is meant by "capital gains". Capital gains is the income that a person gets from the sale of an investment. These investments may take the form of a piece of real estate property like a house or a farm. It can also be a family business or even a work of art. The capital gain is basically defined as the difference between the money that is realized from the sale of an asset and the price that was paid for it.

The amount of the tax that is imposed varies and actually depends on a variety of factors, which even include how long the seller has owned the investment/property as well as what type it is. The capital gains tax will not be asked for until the investment/property is actually sold. For instance, if the stocks in your portfolio have been appreciating in value, you can rest assured that you won't have to pay any type of taxes on them unless you have actually sold the stocks.

Investors should also remember that unlike other taxes, the rate imposed on the capital gains tax is not fixed. The rate imposed will depend on how long the asset has been owned. A good example would be an asset that has been owned for less than year. The capital gains tax that will be imposed on the sale of this property will be at the same rate as an ordinary income. On the other hand, the tax rates that will be given on the sale of a property that has been in the possession of the owner for more than a year can end up being lower.

As with all other tax impositions, there are a few rules that you need to be aware of in order to prevent any kind of major tax liabilities.

One rule that you should remember is that in most cases you can completely avoid capital gains tax if the house that you are planning to sell is considered as your principal residence. In order for a house to be considered as the principal residence you must have taken residence there for two of the last five years. The two years imposed don't necessarily have to be sequential years or even the most recent two years. Just as long as you fulfill the two-year rule the government will consider the house your principal residence. In fact, you don't even need to be living at the house at the time that you sell your property.

Mutual Fund Owners Eyeing Big Tax Hit

The end of the year is coming - a time when mutual fund companies distribute capital gains. This year mutual fund shareholders may suffer with huge capital gains taxes despite significant losses in their portfolios. Although stocks have underperformed, many unsuspecting investors will likely see gains in their holdings as panicked fund managers have sold equities in order to pay out their shareholders. This could leave you with a substantial tax bite because capital gains taxes will be collected on stocks which rose prior to the recent free fall. What can you do before you are invited to pay taxes on someone else's gains?

First off, you must find out when distributions will take place. If gains have not been disbursed, consider selling your fund before the tax is assessed. Move your money into exchange-traded funds (ETFs) that have historically limited the capital gains impact on their holdings (they employ a steady, buy-and-hold strategy). Secondly, delay new fund purchases until next year. "If you're going to buy, wait until the fund distributes capital gains before you get in so you don't get taxed on a fund you have not benefited from," advises our expert Nathan Threebes. He further explains: "When investing in mutual funds your assessment of performance should be paired with tax consequences. Don't forget to look for the funds with low turnover ratio, something in 5%-50% range. Turnover ratio measures how often the fund buys and sells its holdings. A ratio of 50% means that the fund sells half of its portfolio, on average, once a year. Funds with low turnover ratios are least likely to generate large taxable capital gains".

If you are selling, shed smaller gains if you have no losers to sell. For instance, if you purchased 100 shares at $10 then added 100 more at $15 - and the stock has risen to $20 - sell the shares you purchased at $15 to limit your taxable gains. This requires accurate record-keeping as to when you purchased and how much you paid. Additionally, consider waiting to sell until after the one-year holding period because long-term capital gains tax rate is lower (a 5% reduction thanks to recent tax laws).

Penny Stocks and Capital Gains

The whole purpose of investing in capital gains or the profits made from the investment or sale that was previous, the real cause is to make sure that on the issue of penny stock or any stocks for that matter is to get more profit on each share base on the sale price and purchase.

And for anyone looking to deal with capital gains penny stocks there are a few things they should know. One of the first things you should note is that the capital gain per share will not be high. The whole reason for penny stocks being penny stocks is that they are available for less than $10 dollars per share. There have been a few stocks that have hit some high markers in terms of gross capital and this ends up becoming a part of the list of the more powerful stock markets. The better option is if you can predict stocks then you choose the right one and purchase a lot which will in turn boost your capital gains, or maybe you would want to go on a more international stock market. Although they are penny stocks they have a possibility to arrive back to their normal share prices.

This is a very good reason why you should check the news letters very regularly, there are quite a number of news letters out there but the best one's will be cheap and will provide you a number of pick ups of stocks that occurred for the first quarter.

Deferring Capital Gains Taxes on Business Property

The tax deferred exchange provides real estate owners with one
of the last true tax breaks and the only method of deferring tax
on the sale of investment and business property. Most
taxpayers know they can exclude the gain on a sale of their
personal residence. Unfortunately, many business and
investment property owners fail to capitalize on the benefits of
another type of tax-deferred exchange, under Internal Revenue
Code Section 1031.

Far too many business owners sell their business and
investment property and pay capital gain taxes because they are
unaware of provisions in the tax code that allow for deferral.
Internal Revenue Code Section 1031(a)(1) states in part that
"no gain or loss shall be recognized on the exchange of
property held for productive use in a trade or business or for
investment if such property is exchanged solely for property of
like kind which is to be held either for productive use in a trade
or business or for investment." Examples of property types that
typically qualify are vacant land, office buildings, warehouses,
farmland, single-family rental units and shopping centers. Even
leases with 30 or more years remaining are considered real
property and can be traded for other real property.

How does one get started? The procedure is fairly simple as
Treasury Regulations issued in April of 1991 provide a
guideline for taxpayers to follow. Once a buyer for the property
to be sold (the "relinquished property") has been found, a
phone call to a selected "qualified intermediary" to assist with
the Section 1031 exchange is all it takes to begin the process.
The qualified intermediary will produce the necessary legal
documentation required to facilitate the exchange process.
Once the closing of the relinquished property has occurred, the
taxpayer has 45 days from the date of closing to identify in
writing to the intermediary the possible replacement properties.
Due to significant restrictions, it is usually best to identify no
more than three replacement properties. The final step is to
close on one of the identified properties within 180 days from
the date of closing of the relinquished property.

Although the 1031 tax code section is very liberal, various
modifications over the years have resulted in a few additional
restrictions. Partnership shares, notes, stocks, bonds,
certificates of trust cannot be exchanged. A taxpayer who holds
a partnership interest or shares in a corporation that owns real
estate cannot trade that interest for similar share interests.
Business owners should consult a tax expert or legal advisor in
this situation.

With the reduction in capital gains tax rates, taxpayers were
given a rare break. However, this break was not as generous as
originally proposed. Most taxpayers are aware of the new
capital gains tax rate of 15 percent, lowered from the previous
28 percent rate. This is applicable for gain generated from the
sale of capital assets held for more than 12 months. At the last
minute, however, Congress altered the tax rate for recapture of
depreciation taken on real estate to be taxed at 25 percent. This
higher rate is applicable for all depreciation taken after May 6,
1997. Combining the 25 percent depreciation recapture rate
with state and federal tax rates could cost a taxpayer who sells
business real estate over to 40 percent or more of their profit.
On the other hand, a property owner who chooses to perform
an IRC Section 1031 tax deferred exchange can defer taxes on
the all of the capital gain! This leaves the prudent exchange or
with the entire amount available for reinvestment.

Many business owners are unaware that personal property used
in a business, such as a medical practice, can be exchanged as
well. The major difference between a real property and
personal property exchange is what the Internal Revenue
Service considers "like kind" property. I.R.C. Section 1031
defines like kind as "...property held for productive use in a
trade or business or for investment." Like kind as it applies to
real property is very broad in definition. Determining whether
personal property is like kind to other personal property
requires a much narrower scope. The Internal Revenue Code
does not define "like kind." The IRS has published regulations
that can be used to decide if an exchange involves like-kind
properties. The Treasury Regulations distinguishes between
two types of personal property: depreciable tangible personal
property (DTPP); and other personal property (OPP), which
consists of intangible and non-depreciable personal property.
DTPP can only be exchanged for other DTPP. These properties
must be of a "like class" or "like kind." In determining whether
DTPP is of a like class the Treasury Regulations designate 13
general asset classes. These classes combine particular types of
personal property into a certain class group. Some examples of
these groups are office furniture and fixtures, information
systems, airplanes and helicopters, automobiles and taxis, and
buses.

The Regulations also designate that personal property can fall
within product classes contained in the North American
Industry Classification System. These numeric codes can be
used as an alternate method to define the characteristics of a
particular property.

OPP is difficult to classify as like kind to other OPP. It does
not fall within the like class safe harbor available to DTPP.
Intangible personal property, such as a lease or copyright, can
be considered like kind to similar intangible property. The
determining factors are the nature and character of the rights
involved and the nature and character of the underlying asset.
Selling a business can create more than one personal property
group in which to exchange. The IRS looks at the sale of a
business as an exchange of each asset to be transferred, and not
the exchange of the business as a whole. The underlying assets
of a business (e.g., lease value, covenant not to compete,
equipment and fixtures) will need to be analyzed in respect to
their comparable replacement property. Each asset is placed
into the proper exchange group. An exchange group is a
subgroup of the total assets exchanged. Every exchange group
will either have a surplus (trading up in value) or a deficiency
(boot). When the total fair market values of the properties
exchanged are different, the value equal to that difference is
called the residual group. The property in the residual group
will consist of cash and other property that does not fit into an
exchange group.

An example of a business exchange would be the exchange of
one medical practice for another. The relinquished medical
practice value consisted of: (1) the medical equipment (x-ray
machines, etc.) and office fixtures; (2) a covenant not to
compete; (3) lease value for the below market lease of the
office; and (4) client patient lists and files. The medical
practice acquired will generally have similar components of
value. To balance this exchange each separate component is
matched up with its like kind counterpart. A surplus in one of
the exchange groups is not taxable as the Regulations allow for
trading up in value. Any deficiency - going down in value -
would be taxable as "boot."

The Regulations provide the non-yielding rule that goodwill
and going concern value in one business can never be like in
kind to goodwill and going concern value in another business.
In the example of the medical practice exchange, the client
patient lists and files would probably be viewed by the IRS as
goodwill, and should not be included in the exchange. A
prudent tax planner would attempt to allocate value to the
depreciable or amortizable personal property, such as the
medical equipment and office fixtures, to avoid this problem.
Additional personal property not eligible for exchange
treatment is inventory. The inventory of a business is held for
resale and does not fall within the definition of Section 1031
property.

Anyone considering deferring tax under IRC Section 1031
should obtain competent tax/legal advice before proceeding
with a transaction. A mistake can be costly.

IRS Tax Audit Strategy

Private placement life insurance is a pre-emptive IRS audit tax strategy that transforms taxable ordinary income and capital gains into tax-free income (with no income tax reporting required under current U.S. Law). Please reference IRS Private Letter Ruling 200244001 (May 2, 2002).

For U.S. Persons with investment income, private placement life insurance provides for compliant, tax-free compounded earnings.

A private placement insurance policy is variable in nature, which allows the insurance company to invest the majority of the premium(s) in a legally separate, segregated account to be managed by either an investment manager of the client's choosing or the insurance company itself. There are no guarantees when it comes to the investment performance (as it varies, so does the death benefit but with a fixed minimum).

The income tax benefits are:

1. Assets inside a life insurance policy grow and compound income tax free.

2. Death benefit paid income tax free.

Domestically in the U.S., investors have traditionally used the tax benefits of variable life insurance policies to invest in mutual funds. In contrast, international private placement life insurance policies allow users to invest in a wider range of investments including hedge funds, private equity, derivatives, and real estate investment trusts (there are functionally no restrictions on the types of investments that can be held and managed inside the policy).

Other benefits include the following:
1. Short-term capital gains (41% Federal/California income tax): exempt from income tax.
2. Bond interest (taxed at 41% ordinary income rates Federal/California): exempt from income tax.
3. Policies in certain jurisdictions (e.g., Cayman Islands): exempt from creditor attachment.
4. IRS audit risks are minimized since assets held under a qualifying life insurance policy are neither subject to income tax, nor is there any required income tax reporting (under IRC §72(e)(5)). In addition to the substantive tax and reporting benefits, for audit purposes there would be no presumed IRS tax avoidance, due to the fact that life insurance has been granted an "angel exception" (i.e., is an IRS approved transaction) (IRS Revenue Procedure 2004-65, 2004-66, 2004-67, 2004-68).
5. Policy lifetime withdrawals may be tax-free and not subject to tax reporting (as either a return of premium/basis or a loan). The Modified Endowment Contract ("MEC") rules may or may not apply depending on policy design.

Taxes - The Bane of Civilization

Taxes are a levy imposed upon people or legal entities by a governmental entity. There are many forms of taxes including income taxes, property taxes, capital gains taxes, consumption taxes, excise taxes, retirement taxes, sales taxes, tariffs, toll taxes and transfer taxes. This article focuses on reducing income taxes for real estate owners.

Income taxes often seemed unavoidable. However, real estate investors have multiple opportunities to defer and reduce federal income taxes. Real estate owners receive income tax breaks not available to investors for many other asset classes. These include depreciation, income tax rate reduction, and the like-kind exchange. This article discusses how real estate owners can reduce income taxes by increasing the level of depreciation, using tax-deferred changes, casualty losses, maximizing expenses and planning to minimize estate taxes.

Depreciation is a non-cash expense which can both defer and reduce the level of federal income taxes. In some cases, depreciation actually eliminates federal income taxes. When an owner claims depreciation, and does not sell the property before it passes into his estate, the income deferred by the depreciation is never taxed.

Most real estate owners know depreciation defers federal income taxes. Few know real estate depreciation also reduces federal income taxes. The common perception is that depreciation simply shifts payment of income taxes from when income is earned until property is sold. However, depreciation often changes the character of income from ordinary income to capital gains income.

Consider the following example: George purchased an apartment complex in 2005. After obtaining a cost segregation study, approximately 20% of the cost basis of the improvements was allocated to 15 year property, such as landscaping, paving, sidewalks, parking lot striping and exterior signs. If George sells the property in five years, one-third of the cost basis of the 15 year property will have depreciated. Isn't it also reasonable the market value of this property will be one- third less than when the property was purchased?

More often than not, tax preparers believe the market value of short-life property is similar to the remaining basis when property is sold. This means there is no gain upon sale. Hence, additional depreciation was taken for short-life property (which could be used to reduce income taxable as ordinary income rates) while George owned the property. At time of sale, the portion of the gain equal to the short-life depreciation is taxed at the capital gains rate. This is how cost segregation reduces federal income taxes. Hence, federal income taxes are both deferred from the time income is earned until a sale occurs and the tax rate is reduced from the ordinary income tax rates to the capital gains rate.

Cost segregation can lead to meaningful deferral of federal income taxes. However, its most significant power is its ability to convert income taxed at the ordinary income rates to income taxed at the capital gains rate.

A like-kind exchange allows you to defer recognizing gain after selling of property if you purchase a "like-kind" property. Most exchanges of real estate for real estate qualify as a like-kind exchange. It is not possible to exchange real property for personal property and receive the benefits of a like-kind exchange. There may also be some limited interests in real estate, other than a fee simple interest, which do not qualify as real estate for purposes of a like-kind exchange. This might include exchanging the interest in leased land with five years remaining on the lease for fee simple title to another parcel.

The basics of executing a tax-free exchange are fairly simple. You must identify the replacement property within 45 days of the time you sell your property. You can identify up to three replacement properties or an unlimited number of replacement properties whose market value does not exceed twice the value of the property you sold. The replacement property must be purchased within 180 days of selling your property. A qualified intermediary must handle the exchange. To defer all of the gain, the market value, debt and equity of the replacement property must be equal to or greater than the market value, debt and equity of the property that was sold. Rules for like-kind exchanges are rigid, but there are experts who can guide you and allow you to legally defer substantial amounts of income.

A casualty loss for real estate investment property could include fire, flood, hurricane, tornado, or mudslide. Real estate owners incur both financial and emotional distress following this type of casualty. There's also a significant amount of work involved to coordinate with the insurance adjuster, tenants, contractors, vendors and lender. Even if the owner has complete insurance for building repairs and business interruption, a casualty loss deduction can legitimately be taken.

Casualty losses provide the opportunity to depreciate a large portion of the cost basis of real estate. The basis for calculating a casualty loss is the value of the property immediately before the casualty versus the value of the property immediately after the casualty plus insurance proceeds.

Consider the following example: a 200 unit apartment complex in Beaumont Texas was flooded with 3 feet of water on the first of two stories. The owner has casualty insurance expected to cover 100% of the cost to recover repair the property. He also has business interruption insurance to cover lost income while construction occurs and the property is leased. The initial reaction in reviewing this situation may be there is no casualty loss since the physical repairs and lost rents are covered. However, the market value of the property immediately after the casualty is substantially less than the market value of the property before the casualty. It is highly unlikely someone would purchase the property and agree to undertake the work required to negotiate with the insurance company, contractors, tenants, vendors and the lender without expecting a profit for their work. The magnitude of the casualty loss would have been much larger if the owner did not have business interruption insurance. In either case, a real estate investment group seeking to purchase the property immediately after the casualty would likely require an appropriate return for their capital and an entrepreneurial profit for the effort to renovate and lease the property.

Operating expenses are a tax deduction. Increasing operating expenses reduces taxable income and income taxes. Reviewing all cash expenditures annually can reveal operating expenses which have inadvertently been coded as a capital expenditure. Correcting this error prior to filing a tax return increases current year deductions. A fixed asset review can uncover errors which allow for substantial current year deductions. It is possible to claim current year depreciation or deductions after correcting a fixed asset listing. Corrections can be as a result of classifying operating expenses as capital expenditures. Another option for generating current year deductions is identifying assets which have been ascribed in excess of depreciation life. For example, if the cost to install substantial new landscaping was given a 39 year life, depreciation can be increased by correctly assigning a 15 year life and catching up previously under reported depreciation. Combining business and personal travel can increase deductions. Perhaps you need to schedule a business trip. If you add several days for leisure, the cost of the business trip can still be deductible. Scrutinizing personal expenses for lawful deductions can generate additional deductions. Any costs related to investment activity are deductible. This can include a computer at home for maintaining records for rental properties, mileage related to maintaining rental properties and memberships and publications related to investment activity.

Perhaps the most distasteful type of tax is the estate tax. For that tax, advance planning is necessary to substantially reduce estate taxes. While the current year exemption for 2006, 2007 and 2008 is $2 million, those with the states substantially in excess of $2 million need to consider detailed planning to minimize estate taxes. Options for reducing estate taxes include gifts during your life, partial interests, gifts upon death, bypass trusts, and a variety of other options.

Real estate investors are subject to income taxes, capital gains taxes, estate taxes, property taxes, and sales taxes. Real estate investors are fortunate that federal tax laws provide more opportunities to reduce income taxes than are available to most other business owners. In some cases simply consulting with a tax preparer may allow real estate investors to minimize taxes. However, in most cases utilizing a team of tax advisers with specialized knowledge enhances the investor's ability to minimize taxes.