Preparing Income Taxes - Why You Need to Know About Capital Assets

The IRS is in the business of collecting revenue to support our government. It collects taxes on various forms of money we "accumulate". We are taxed on income we earn; on interest we receive on savings, on dividends from stock we own, and from gains or losses from the sale of our possessions. The IRS Tax Code often categorizes these possessions using negative definitions. It is very confusing! According to the IRS, "our stuff" might belong to some category of property UNLESS it is listed as an exception to that category! For example, in IRS-speak, capital assets are defined as any property that is not explicitly listed as an exception! Sounds crazy (or deviously clever)? Let's start with that negative definition...

Some stuff is real and some stuff is personal. Real stuff is typically associated with "dirt"; like real estate, buildings, or just land. Personal stuff is anything that is not real! Personal property is "movable". Your car, your refrigerator, and your lawn mower are stuff you can hold, move, or break. This "stuff" or property is tangible; it has "substance" and usually some intrinsic value. You can also have intangible property like pieces of paper called stocks and bonds. The value of the "paper" is in the rights of ownership it conveys; they are examples of intangible personal property.

Thus, almost all the "stuff" you own for personal or investment use is a capital asset. Your car, your refrigerator, your lawn mower are examples of personal-use property. The definition begins to blur though because while your home is real, personal use property, a rental home that is not your residence would be business-use property. That rental is maintained to produce some form of income. It might also be considered investment-use property because it has the potential to increase in value over time.

But there is an even more important classification the IRS relies on to collect revenue: holding period. When "stuff" is owed for periods of time that exceed 12 months and a day, the gain or loss from the sale of that property is classified as long-term rather than short-term. The net capital gain is the difference between more preferably long-term gains (or losses) over short-term gains (or losses). The tangible "stuff" you use for non-business or personal reasons is called a capital asset. When you sell this kind of "stuff", any profit or amount over the "original cost" is considered a capital gain and, most important, is taxable. You are required by law to report a capital gain on your income tax return. Depending upon the size of a capital gain, you might also need to make an estimated tax payment! You calculate the gains or losses on Form 1040, Schedule D, Capital Gains and Losses and transfer the net amount to Line 13 in the income section on the top page of your IRS Form 1040. You can find out more information on the IRS website, IRS.gov.

It Is Time to Plan the Sale of Assets and Your Capital Gains Tax Liability

The New Year is here and yes it is time to look at your assets and see what you can do to exploit the favourable taxation of capital assets. There is little time to plan and to execute tax planning strategies before the 5th April so review your assets and act now.

Planning:

I always advocate planning; do not cheat! You will never be able to wipe out entire tax liabilities but with careful planning you should be able to save several small to medium amounts thus justifying the overall plan.

Is it a capital gain?

Obvious but some people jump in and do not realize that what they are planning does not give rise to a Capital Gain. Ensure that when you consider the taxation of the sale of an asset the correct charge is to Capital Gains Tax rather than Income Tax.

In your planning also consider Inheritance Tax.

I find that when taxpayers sell assets they are drawn immediately to considering capital gains tax. The first option to tax is as trading profits rather than capital gains. The deciding factor is whether or not the intention at the time of purchase is to make a profit from the resale, with or without improving the asset, within a short time scale.

As the sale of land and property are the sale of capital assets, a high percentage of taxpayers are drawn to capital gains to tax the profit. HMR&C does not. They fully review the transaction to see if it is a transaction in the nature of trade.

If this fails, the next attempt is to tax it under a little known provision where land, or any property deriving its value from land, is acquired with the sole or main objective of realizing a gain from the disposal of the land, or land is held as trading stock, or land is developed with the sole or main object of realising a gain from the land when developed. The section states that it is enacted to prevent the avoidance of tax by persons concerned with land or the development of land.

You can see that a transaction resulting in a profit of a capital nature could result in the profit being taxed as income. This legislation covers all individuals whether resident in the U.K. or not, so long as the land is situated in the U.K.

Tax free amount:

Every individual has £10,100 tax free each year. Although tax rates are lower for Capital Gains than they are for Income Tax it is still a worthwhile saving especially as you can take advantage on an annual basis.

The £10,100 not used by one person cannot be transferred to an other, married or not. If not used it is lost.

The strategy is to annually review your assets and see what you can realize to make a gain of less than £10,100 rather than wait for the natural disposal. The result is that the tax free amount can be compounded in value by reinvesting in a profitable investment.

Bed & breakfast to spouse & ISA:

A married couple can transfer assets between them without attracting liability, the asset passing to the other at a value that gives rise to neither gain nor loss. By spreading the ownership you immediately have a further tax free amount of £10,100.

You may want to bed and breakfast your investments at the end of the year in order to wipe out some of the accrued gain.

There is legislation that prevents this but there is nothing that stops you bed and breakfasting with your spouse/civil partner.

You sell and your spouse/civil partner buys thus keeping the holding in the family but having removed part of the taxable gain.

It appears from a guidance note issued by HMR&C that they find the sale of an asset standing at a loss and with the other spouse/civil partner repurchasing it to be unacceptable so take care and seek professional advice.

An alternative strategy is to sell the shares and buy them back through an ISA.

You can then have them in a tax-free vehicle for the rest of your ownership.

An ISA is in effect a tax haven. You can sell assets into the ISA and capital gains up to £10,100 are tax-free.

Joint Tenants v Tenants in Common:

Usually spouses/civil partners hold property as joint tenants. This means on death the property passes automatically to the surviving spouse/civil partner.

If the property is transferred to ownership as tenants in common, you are free to dispose of your share as you please either during your lifetime or by your will.

This adds to the planning opportunities and should be discussed with your adviser.

If you own property solely I suggest you see a solicitor as you could transfer the ownership to tenants in common.

Only transfer 1% and retain 99%. If you do not elect for the income to be split in that proportion it will automatically be dealt with under the 50:50 rule so the income is shared but the capital remains 99% yours.

This could be done by declaring a trust in favour of your spouse. HMR&C will accept the transfer took place on the date the document is signed. HMR&C have confirmed that such a trust is effective.

Residence:

Co habitees have an advantage over married couples where two houses are owned as each of the co-habitees is entitled to a principle residence free of tax if the other conditions are met, whereas a married couple is only entitled to the one exemption.

Losses:

In your annual review if you have made profits see if there are any assets that you could sell at a loss which can then be set against the chargeable gains thus reducing the tax payable.

If you have an asset that has become worthless you do not have to wait for the ultimate sale; you can claim the loss. For shares there is a published list which shows when HMR&C have accepted that a share has either become worthless or has negligible value.

If you have subscribed for shares in a trading company that is not listed on a recognized stock exchange and have lost your investment due to the shares becoming worthless, you can claim to have your capital loss set against your other income for that year or the previous year.

Losses c/f:

Where there is a capital loss brought forward and the chargeable gains do not exceed the annual exemption no deduction is made for the losses brought forward. They are preserved and are available to be carried forward.

Timing:

The date of disposal of an asset is the time when the contract is made and not when the asset is conveyed or transferred.

This means the exchange of contracts and not completion. For a conditional contract it is the date on which the condition is satisfied.

A sale timed for February 2011 delayed until after 6th April, 2011 will delay the tax payable from 31st January, 2013 to 31st January, 2014

This is a simple tactic but the interest earned could be substantial.

Purchase of own shares:

If you want to retire from your company, one way is for the company to buy back your shares.

If this happens you should seek advice as the transaction can be treated as giving rise to either an income or a capital distribution.

It will depend on your circumstances which is best for you; especially with the high Income Tax rates and as after Entrepreneurs Relief Capital Gains are taxable at 10%. I know the rate at which I would prefer to pay.

Peter Clare

The Poacher turned Gamekeeper

This information has been honesty written with a view to helping you: I am, like most people, not perfect and I apologise for any incorrections. I cannot be held responsible for any consequences of you using the information unless I have been made aware of the full facts of the matter and have expressed an opinion thereon.

Deferring Taxable Gain on the Sale of Your Business Or Real Estate Assets

Business owners who sell a business, assets held or used in their business, or real estate used in their business operations can face significant capital gain taxes.  These capital gain taxes due from the sale of your company, assets or real property can be minimized or even eliminated with the proper tax deferral or tax exclusion planning in conjunction with your legal and tax advisor. 

There are numerous tax deferred and/or tax exclusion strategies available for the sale of businesses, assets and real estate.  It is critical that careful tax planning be a priority in order to properly deal with the potential capital gain taxes that will be generated by the sale of your property.

The 1031 Tax Deferred Exchange May Not Be Suitable

Owners of real or personal property, such as a business interest, assets used in a business or real property that have been held for rental, lease, investment or used in a trade or business, frequently structure tax-deferred exchanges pursuant to Section 1031 ("Section 1031") of the Internal Revenue Code ("Code") in order to defer the payment of their taxable gains.

However, tax-deferred exchanges pursuant to Section 1031 are not always feasible, suitable nor appropriate for taxpayers when they are selling their company, assets used in their company or real property used in their business operation. 

Section 1031 Exchange transaction structures require business or property owners to exchange equal or up in net sales value by acquiring one or more replacement properties that are of like-kind.  Locating suitable replacement properties to be acquired as part of the Section 1031 Exchange in order to replace the relinquished property (business) can be extremely challenging, very stressful, and virtually impossible in some cases. 

The taxpayer may have absolutely no wish to reinvest his or her net sale proceeds into another business operation of like-kind, or any kind, for that matter.   Taxpayers may just wish to "cash out" and pay their taxes. 

Taxpayers may have reached a point in their life when they merely wish to sell, cash out, pay the taxes, and absolutely not reinvest in another business, assets or real estate. They may not even want to see another business as long as the live.  Some taxpayers may opt to sell and pay their capital gain taxes in the current year, but many would prefer to implement some kind of tax deferral or tax exclusion strategy that would allow them to defer the payment of their taxable gains over a period of time of their choosing rather than get hit with them all in the year of sale.

Deferring Capital Gain Taxes Without a 1031 Exchange

There are a number of tax deferred and tax exclusion strategies available that a taxpayer can use to defer the payment of taxable gains, so it is important that the taxpayer meet with his or her tax advisor to review all of their tax strategies. The following are the two most common tax-deferral strategies available for the sale of businesses, assets used in your business or real estate:

Seller Carry Back Note (Seller Financing)

The taxpayer could structure the sale of his or her business operation by carrying back a note, which is often referred to as seller financing or a seller carry back note. Seller financing is merely an installment note or promissory note where the buyer of the business entity or assets/property makes periodic payments to the seller. Depreciation recapture taxes, if any, are due and paid in the year the business, assets or real estate were sold. The capital gain taxes are partially or fully deferred over the term of the note and are taxed as principal loan payments are made to the taxpayer.

The installment note or promissory note strategy has positive and negative features. The obvious positive is that you can sell your business, asset or property and defer the payment of your taxable gains by structuring a seller carry back note.

However, the risk of buyer default on the installment note is a considerable negative. The process to foreclose or otherwise take back the business or asset/property can consume significant amounts of time and money and the business, asset or property may have been irreparably damaged during the buyer's ownership and management.

Deferred Sales Trusts or DSTs

Deferred Sales Trusts or DSTs are highly effective tax-deferred strategies, similar to the installment sale or seller carry back note, but without the risk of buyer default.  The Deferred Sales Trust receives all of the net cash proceeds from the buyer at the closing of the sale transaction, thus removing the buyer from involvement in the Deferred Sales Trust  transaction.  Deferred Sales Trusts can provide other great tax and estate planning strategies as well.

Deferred Sales Trusts are drafted pursuant to Section 453 of the Internal Revenue Code, just like the installment sale note or promissory note in seller financing. The capital gains tax is realized or triggered, but not recognized or paid, because it is deferred over a period of time selected by the taxpayer.

The capital gains tax liability is partially or fully tax deferred over the term of the installment sale note created within the Deferred Sales Trust account, which you will negotiate in advance directly with the Trustee of the Deferred Sales Trust. 

Preparing Income Taxes - 2 Ways Capital Assets Save You Money

What is a capital asset? Tax authorities like the Internal Revenue Service and state taxing authorities expect you to report any capital gains or losses on your annual income tax return. This information is reported on IRS Form 1040, Schedule D, Capital Gains and Losses and then transferred as a "cumulative" net amount to Line 13 in the income section on the top page of your IRS Form 1040. You can't file an income tax return that has capital gains or losses using IRS Form 1040A if you are required to file Schedule D to report the income.

Why should you care what is or is not a capital asset? It is important because it could save you money! Tax rates applied to capital gains income are often significantly lower than a person's marginal income tax rates. In other words, you often owe less tax if you sell a capital asset! For 2009 and 2010, a taxpayer in the 15% marginal income tax bracket will pay 0% on any net capital gains! But there is yet another way it can save you money.

The second way you can save money is if your capital loss is greater than your capital gains for the tax year. If gains are less than your losses, you have a cumulative or net loss. This means you can deduct up to $3000 ($1,500 if you are married but filing separately) from your income tax. If the loss is greater than this annual limit, you can "carry forward" the unused loss into future years until it is all used up. There is a catch, though. You can deduct a capital loss only on investment property; you can't deduct a capital loss on personal use property. This distinction is important; you typically don't own investment property, according to IRS code, for personal enjoyment! It is also important to remember that if you anticipate a significantly large taxable capital gain during the year, you are required to make estimate tax payments (even though it will be taxed at a preferentially lower rate).

Your understanding of the definition of a capital asset and how you dispose of it is an important part of managing your personal finances. More information is available in IRS Publication 544, Sales and Other Dispositions of Assets or on the IRS website, IRS.gov. Knowing the "rules" about capital assets could save you lots of cash AND grief.

Tax When You Inherit Money, Assets Or Property

Usually, you don't have to pay any sort of inheritance tax when some assets, money or property are left for you by the deceased one. In most cases, you get the inheritance after paying out the inheritance tax over it, but some situations may need to pay some sort of taxes.

You may need to pay three sorts of taxes regarding some inheritance, and these taxes can be in the form of income tax, capital gains tax, and inheritance tax. Let us find out in which conditions, you might have to pay these taxes.

If the items that you are going to inherit can generate taxable income for you, it is possible that you will have to pay on this inheritance. Usually, shares dividends, interest, and rental income are the incomes on which you might have to pay some tax over.

Similarly, when it comes to capital gains tax, this tax might be payable when you give away, sell or exchange some inherited asset. Often it goes up in value from the time of death. 'Dispose of' is what we call it in legal terminology that can be ceased to have an asset. If the inherited asset gains some value between the time of death, and disposing of date, this increase is known as capital gain, and you might have to pay some tax over it.

When it comes to inheritance tax, usually, this type of tax is not paid on property, assets, or money that you inherit, as this tax is taken out from the estate of the dead one. However, you need to pay this tax in certain situations for instance, you might need to pay this tax if the estate of the deceased cannot pay it, or if it is said in the will that the inheritance tax will be paid by you.

If you inherit some property from your spouse, you are considered an exempted beneficiary, and you will not owe inheritance tax, if you have been domiciled in the UK. However, if some property is owned jointly with the dead one who was not your spouse, the personal representative, or executor of the deceased need to pay debts, or inheritance tax before the distribution of the estate in its beneficiaries.

More often, it is paid by making the most of some other funds that come from different parts of some estate. If the debt or outstanding tax cannot be paid from the rest of the estate, you might have to sell the property.

You may need to pay Capital Gains Tax if your inherited asset is a property in which, you live in from its inheriting time to the time of its disposal, you may not need to pay Capital Gains Tax. If a second property is inherited disposed of, it is possible that you have to pay inheritance tax on this second property. Besides these situations, there is no other well known situation in which, you may need to pay any tax on your inherit money, property or asset.