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).

Top Ten Tax Tips For Foreign Property Owners

1. Don't Forget You Still Have UK Tax To Pay!

Arguably, this is more of a warning than a tip, but it is vital to remember that any UK resident individual buying property abroad is still exposed to UK tax on that property. This may include UK Income Tax on rental income, UK Capital Gains Tax on property sales and UK Inheritance Tax on any foreign properties you leave to your children.

The UK tax burden is often greater than any foreign tax liabilities, so it makes sense to undertake UK tax planning for your foreign property. Many of the same planning techniques that work well on UK property can be used equally on foreign property, although the overseas angle adds an extra dimension and brings both additional opportunities and additional pitfalls to be wary of.

2. Main Residence Relief for Foreign Holiday Homes

There is nothing in the UK tax legislation to say that a foreign holiday home cannot be a UK resident individual's main residence for Capital Gains Tax purposes.

A holiday home can be treated as your main residence by making an election to that effect, generally within two years of buying the property.

The foreign property must be your own holiday home for at least part of the time but, by making the election, you will be able to exempt some or all of the capital gain on your foreign home from UK Capital Gains Tax.

Beware, however, that you're only allowed one main residence and, if you're married or in a civil partnership, you're only allowed one between you, so electing to treat your holiday home as your main residence could backfire if you sell your main house back in the UK.

You can get the best of both worlds though, if you only elect to treat your foreign property as your main residence for a short period, say a week. How does this help? Well, since every main residence is also exempt for the last three years of ownership, that week buys you three years. In other words, you lose one week's worth of exemption on your main house but gain three years (and a week) of exemption on your foreign holiday home.

3. Travel at the Treasury's Expense

If you're renting out foreign property, you have a foreign rental business. Like any other business, you're entitled to claim tax relief for your business expenses. That includes any travel costs which you incur for business purposes.

Furthermore, all foreign property rentals are treated as one business. Hence, for example, you could claim the cost of going to Dubai to look for a possible new rental property against the rental income from a villa which you already have in Spain.

4. Understand the Local Taxes

Most countries will tax foreigners on any property they own in the country. Local taxes often apply to property purchases and sales and to rental income. Furthermore, you will often have to pay annual taxes on foreign property, even if you do not rent it out, and many countries also have gift and death taxes.

You will get double tax relief in the UK for any foreign tax on the same income or capital gains when the UK accepts that the foreign tax is broadly equivalent to the UK tax you are paying.

Beware, however, that every country has a different tax regime and not all of them are compatible with the UK tax system. If you suffer a foreign tax which is different in character to any UK tax, or which arises when no UK tax is due, you may not get any relief for it in the UK.

So, a foreign tax at 30% which is deductible from your UK tax liability on the same income may actually cost you less than a foreign tax at 10% for which no double tax relief is available. All these factors need to be considered before you invest in foreign property.

5. Do You Want Double Tax Relief?

As a general rule it is usually worth claiming double tax relief for any foreign taxes whenever you can. By claiming double tax relief, you deduct the amount of foreign tax paid from your UK tax liability.

However, you cannot get any repayment of foreign tax through a double tax relief claim and the best you can ever do is to reduce your UK tax liability to nil.

Sometimes, the foreign tax may actually exceed the amount of the taxable income or capital gain for UK tax purposes. In these situations, it is better to claim the foreign tax as an expense rather than to claim double tax relief.

Where you claim foreign tax as an expense, it reduces the amount of the taxable income or capital gain and can even create a loss. This loss can be carried forward to give you future tax relief and hence, in some situations, can actually give you better value for your foreign tax than a double tax relief claim.

6. Reduce Your Foreign Exchange Tax Risk

All UK tax calculations for individual taxpayers are carried out in pounds sterling. This creates some particular problems when it comes to capital gains on foreign property. You may make very little gain in the local currency, but when you translate your purchase and sale costs back into sterling, you may have a big Capital Gains Tax exposure in the UK.

Let's say you buy a property in Utopia for 100,000 Utopian Dollars at a time when the exchange rate is two Utopian Dollars to the pound. That means you have a purchase cost of £50,000.

Later, you sell the property for 120,000 Utopian Dollars. In local terms, you have a modest gain of 20,000 Utopian Dollars. However, let us suppose that the exchange rate is now 1.2 Dollars to the pound. This means that your sale proceeds for UK Capital Gains Tax purposes are £100,000 and you have a taxable gain of £50,000.

Maybe that's fair: after all, if you bring the money back to the UK, you will have made a profit of £50,000 on your investment.

Beware, however, that if you hang on to your Utopian Dollars, they will become a new chargeable asset for UK Capital Gains Tax purposes and may give rise to a capital gain or capital loss when you eventually spend them or exchange them into sterling or any other currency.

The real problem to watch is that if you make a capital loss on your foreign currency in a later UK tax year (year ended 5 th April), you will not be able to set that loss off against the earlier capital gain on your foreign property.

The tax tip here, therefore, is to make sure that you dispose of your foreign currency sale proceeds in the same UK tax year as you dispose of the foreign property itself.

7. Get VAT back with leaseback

In the UK, we are accustomed to the idea that any purchase of residential property is exempt from VAT. This is not the case in every country, however, and many European countries charge VAT, at rates of up to 20%, on new residential property purchases.

One way to recover the VAT on such a purchase is to enter into a 'leaseback' scheme. Under these schemes you, the owner, lease the property back to a hotel operator. This means that your property becomes a business property and you are able to recover the VAT. Typically, you are allowed a few weeks of personal use of the property each year and, eventually, after a suitable number of years, it is yours outright again.

The scheme only works for certain types of property, such as hotel rooms and apartments, and may carry disadvantages for other foreign taxes, such as higher Income Tax rates; so it's one to investigate carefully before you sign up.

8. Borrow to Save

Many countries impose Wealth Tax, Inheritance Tax, or both, on foreigners owning property in their country.

Wealth Tax is usually an annual charge on the property owner's net wealth in the country.

Foreign Inheritance Tax also usually applies only to a foreigner's net assets in the country.

In most cases, you can reduce your net wealth in the foreign country for tax purposes by taking out a mortgage on your foreign property. In this way, it will usually be just your net equity in the property which attracts foreign tax.

If you don't actually need a mortgage, you can invest the borrowed funds somewhere else outside the country where your property is located.

9. Avoid Evasion

When you buy property in a foreign country, you will usually also be acquiring tax obligations in that country. In fact, many countries require prospective foreign property purchasers to register themselves with the local tax authority before they can complete their purchase.

If you want to sleep at night, you need to make sure that you fulfil your local tax obligations in the country where your property is situated. Many foreign tax authorities have the power to seize property where taxes are unpaid.

Naturally enough, the local tax authority will write to you in their own language. Do not ignore this correspondence just because you don't understand it: this is no defence. You will need local help and advice to make sure that you deal with the local tax authority appropriately and meet all of your obligations as a taxpayer in the country.

10. Expect the Unexpected

If the UK tax system is all Greek to you, or seems like Double Dutch, why should you expect foreign taxes to be any different? Every country has its own tax and legal system and, when you buy property abroad, you must abandon all of your preconceptions.

Assume nothing until you have investigated the local tax system thoroughly. Your destination country will have different taxes, different tax rates, a different tax year and a whole different set of rules, regulations, reliefs and exemptions.

Local property law and succession law is likely to be different too and a UK investor who overlooks this fact may suffer a great deal more than just tax!

2011 Capital Gains Tax Increase and the Impact on Business Owners

The last couple of years have been difficult for business owners and financing markets, to say the least. Limited credit, economic uncertainty among businesses and consumers, and poor financial performance across industry sectors contributed to curtailed growth prospects, and have some wondering what their long-term strategy might entail. As we head into 2010, however, there are many reasons for optimism that merger and acquisition activity will increase, including improving economic indicators, cash heavy balance sheets of strategic buyers, better than expected fund raising by private equity groups and Key Take Aways increased confidence in the private and public sectors. For potential sellers, 2010 is also an important time to consider valuation risks now versus future years due to the scheduled increase in the capital gains in 2011.

Originally signed into law in 2001, the capital gains tax rate was reduced as part of President Bush's Economic Growth and Tax Relief Reconciliation Act. Under the reduced rate, long-term capital gains and qualified dividends were taxed at 15% for the lowest two income tax brackets. The lowered rate was set to expire in 2008; however, reduced rate was extended in 2006 under Bush's Tax Reconciliation Act and is scheduled to expire at the end of 2010, at which time the rate will revert to the 2003 rates, which were 20%.

Given the capital gains tax rate increase represents a 33.33% higher effective tax rate, there is significant motivation for owners and shareholders already considering a potential sale in the near-term to consider action in 2010. Beyond avoiding a higher tax rate on long-term capital gains, sellers also need to carefully plan the timing of a potential exit in 2010 in order to secure the most attractive buyer and preserve leverage in the negotiations of the purchase agreement.

While owners and shareholders may be hesitant to pursue an acquisition without greater economic certainty, there are multiple indicators suggesting that 2010 is likely the right time to at least consider a potential a sale, given favorable terms. The capital gains tax increase serves as motivating factor; it is by no means the only one.

The following are key points for understanding the impact of the capital gains tax rate increase on M&A activity in 2010:

Consider the overall economic picture.

There are signs at the corporate level that are encouraging to mid-size firms considering being acquired. Over the last three months through January 2010, deal flow is up 16.8% over the same period a year before. Of course, last year was the one of the worst years in our economic history. However, major deals are being completed, which can cause a "bandwagon effect." In addition to corporate confidence, many private equity groups with a strong track record continue to raise money. In 2009, the average fund size raised by private equity groups was $1.5 billion, the second highest on record. This indicates more private equity groups than expected will have cash in 2010 and will need to put it to work. With a return in confidence to the markets and increasing signs of an economic stabilization, 2010 is likely to see a number of buyers enter the market with cash on hand seeking good deals.

Understand your long-term growth realities.

While the economy is expected to undergo further recovery in 2010, many mid-size firms are simply not going to be able to grow at the same rates experienced in the 2003-2008 period. Given modest growth expectations, overall business growth in the next three to five years will not be significantly higher than its current state in 2010.

It is projected that the economy will grow at an average rate of less than 3.5% for the next 3-5 year, which will mimic the growth of most industries. (There are, of course, exceptions to every rule.) Given this outlook, a company should consider a realistic growth projection as part of their calculations for keeping their business or selling it now or five years from now. This is especially so considering what will most likely be a higher capital gains tax rate in 2011 and beyond.

Think critically about timing.

Early in 2010, the market will be more favorable to sellers, who will have a range of potential buyers to choose from. Moreover, the capital gains tax rate increase puts buyers not paying all cash at a disadvantage, since the increased tax rate will apply to deferred payments at the time the payment is made. Deferred payments are likely to continue into 2011 and beyond for non-cash buyers. Therefore, sellers are more likely to find buyers with cash in hand earlier in the year.

In addition to increased choice of buyers, owners are in a better negotiating position earlier in 2010. As potential buyers know that sellers have a range of options and varying deal structures to minimize tax obligations, they are more likely to agree to terms favorable to the seller. As 2010 progresses, the buyer will be able to use the impending tax increase as leverage in deal negotiations, aware the seller has significant motivation to close before 2011. In fact, if negotiations are still ongoing in 4Q10, buyers are likely to try and discount the purchase price by 1% to 5% or seek tougher terms in the purchase agreement, knowing the seller will try and avoid paying the higher tax rate.

While not appropriate for all owners, those considering a sale in the near-term future are likely to experience favorable conditions 2010 as closing before year end avoids paying higher capital gains taxes. Additionally, early movement will prove advantageous for sellers by yielding a greater range of potential buyers and a strong position in deal negotiations. Overall, 2010 is likely to experience a significant revival in M&A activity, attracting a number of interested buyers to the market.