Knowing The Rules Will Save You Money-The Truth About Capital Gains and Losses

The average American taxpayer lets the chips fall where they may when it comes to reporting capital gains and losses on their tax returns. So that we all understand, let's review the rules for capital gain and loss netting. Capital gains and losses are divided into two types; long-term and short-term. A long-term transaction is one that involves the holding of a given asset for more than one year. Conversely, a short-term transaction involves the holding a given asset for less than one year. The importance of the holding periods relates to the rate of income tax to be paid on the transaction. Under current law, long-term capital gains are taxed at a maximum rate of 15%. Short-term gains are taxed at the maximum incremental rate of the taxpayer. This rate could be as high as 35%. Long-term capital gains and losses net against each other as do short-term capital gains and losses. To the extent that losses exceed gains, the capital losses will offset other forms of income up to $3,000 with the balance being carried forward indefinitely. The capital loss carry forward will maintain its respective classification as either long-term or short-term.

The tax planning opportunities for recognizing capital gains and losses are a plenty believe it or not. First of all, it is important to point out that the amount of the gain or loss to be recognized can be controlled. There are two ways to recognize capital transactions. The first in first out method (FIFO) assumes that the first or oldest asset acquisition is being sold. The FIFO method is the default method for recognizing gains and losses if the specific identification method is not used. The specific identification method allows the taxpayer to identify which asset (or block of shares) is being sold. For example, the taxpayer owns two blocks of IBM shares as follows:

September 1, 1990 1,000 shares at $30 $30,000

September 1, 2004 1,000 shares at $50 $50,000

On November 1, 2006, the taxpayer wants money to pay bills and pay college tuition. On this day, the price of IBM shares is $45 per share. Let's assume that the taxpayer does not have any capital loss carry forwards. To avoid paying long-term capital gains tax of $2,250 (15%x$15,000), the taxpayer notifies his broker in writing that he wishes to sell the September 2004 block of shares. This would create a long-term capital loss of $5,000 ($45,000 selling price less $50,000 acquisition cost). If there are no other capital transactions for the year, the taxpayer will get a $3,000 capital loss deduction against other income. Assume a 35% tax rate and this taxpayer gets a $1,050 tax savings in 2006. By knowing the specific identification rules exist, the swing in tax savings is $3,300 ($1,050+$2,250). The remaining balance of capital loss is $2,000 ($5,000 less $3,000 recognized) and is carried forward as a long-term capital loss indefinitely.

Another key tax planning tactic involves the timing in netting capital gains and losses. Let's assume that a taxpayer has the following transactions during the year:

Long-term capital loss carry forward of $20,000

Short-term capital gain on stock transactions, $20,000

Long-term capital gain on sale of land, $20,000

Taxpayer is in the top tax bracket of 35%

In this example, the long-term capital gain must first be netted with the long-term capital loss. This will eliminate the 15% tax on the long-term capital gain of $20,000. The tax due on capital transactions in the current year will be $7,000 ($20,000 x 35%). What could this taxpayer have done differently? Suppose he could have gotten a contract to sell the land in the next year. This would then allow the short-term capital gain to be reduced by the long-term capital loss. Remember that capital gains and losses must first be netted within their respective classes. After this ordering, any leftover long-term or short-term loss can be netted against the other category's gain. If the taxpayer holds off the land sale until next year, the short-term capital gain goes to zero in the current year. In the year to follow, the taxpayer will pay $3,000 in long-term capital gains tax (15% x $20,000). This not only saves the taxpayer $4,000 in tax on capital transactions ($7,000-$3,000), but postpones the payment of tax for one year.

In summary, understanding how capital transactions work can provide taxpayers with the potential to save a significant amount of income tax. Don't just let the chips fall where they may, take a look at what you have and keep records. This is a classic example of knowledge is power.

Listen to my show every Saturday morning at 10 on WBIS Am 1190. "Better Business" is the most complete business program on radio and MY WAY IS definitely BETTER.

Avoid Capital Gains Tax When Selling Real Estate

You can cut the capital gains tax out of a real estate sale with the use of Exchange 1031. Exchange 1031 provides that if you are going to use proceeds of the sale of a real estate property to purchase additional property, you can avoid paying the capital gains tax.

The idea is to bolster real estate sales by allowing taxpayers to waive this tax on your property sale if the main purpose of the sale is to purchase another property. This provision gives an incentive for both the buying and selling of property.

Capital gains taxes assessed in the sale of real estate are estimated at around 20%-30%. If a taxpayer is engaged in a "like kind" real estate purchase, the tax reduces his ability to purchase a similar property by effectively cutting the resale value of their property by 20%-30%. This, in turn, will reduce the amount of money that they are likely to spend on a "like kind" purchase of another property.

There, of course, are conditions to deferment of capital gains tax under Exchange 1031.

The value of the property you are purchasing with the proceeds from the sale of your property must be equal to or more than the net profits from the selling of your property.

The full equity realized from the sale of your property must be used to purchase the "replacement" property.

If the replacement property you purchase under an Exchange 1031 provision turns out to be of lesser value than the property you sold, you will be liable to pay an accrued tax. The amount of your tax liability will be determined by the amount the replacement property fell short of the full equity of the sold property.

In other words, the amount of tax liability you incur will depend upon your given situation and the amount of full equity you realized after the sale of your property. Therefore, part of the tax is deferred in this instance, rather than deferring all of the capital gains tax.

The hope of this provision is that such a substantial tax savings will encourage real estate sellers to purchase "replacement" property rather than invest the income from such a sale of real estate into some other venture. It is a good provision for people looking to "buy up" in the housing market.

Taxation of Professional Stock Traders

The tax rules for stock investors in general requires three steps. Step one is the netting of short-term capital gains and short-term capital losses. Step two is the netting of long-term capital gains and long-term capital losses. Step three is the netting of net short term gains/losses and net long-term gains/losses. Any capital losses in excess of $3,000 are carried forward indefinitely to offset future capital gains plus $3,000 of ordinary income every year, until the capital losses are used up. But what if you are a "day trader"? What special tax rules exist for day traders? This article will address those unique tax rules that apply to day traders.

What is a day trader? In general, a day trader, is anyone who engages in the business of trading stock. You are in the business of trading stock, and thus not an ordinary stock investor, when the frequency of your trading activity is such that it meets the "material participation" test. Qualifying as a trader under this material participation test is difficult because one must be active in the securities markets on a daily basis and attempt to profit from short-term swings in security prices. Many online investors fail this test, but some day traders (most of whom are also online investors) meet the standard. InPurvis [37 AFTR2d 76-968, 530 F2d 1332 (1976, CA-9)], the Ninth Circuit Court of Appeals upheld a prior tax court decision [Purvis, TC Memo 1974-164 (1974)] and agreed with the Tax Court that in order to be classified as trading, the activity should be performed with sufficient frequency to "catch the swings in the daily market movements and profit thereby on a short-term basis." Day traders can take a buy-and-hold approach, but most of them seek to take advantage of short-term market fluctuations and this short-term market fluctuation criteria is the linchpin in qualifying some day traders as traders rather than investors for federal income tax purposes.

What's so important about being considered a trader verses an investor?
Investor losses in excess of $3,000 a year are not deductible in the year of the loss. This excess loss amount must be carried forward. There is no time limit on the future utilization of the excess losses, but if you continue to rack up losses each year, you will be limited, each year, to this $3,000 loss limitation. Traders, on the other hand, are not limited to this $3,000 annual loss limitation. They are able to deduct their entire net loss for the year on their individual income tax return. Traders report their net gains/losses on Form 4797 as ordinary income (investors report their net gains/losses on Schedule D. Net long-term capital gains are taxed at the favorable long-term capital gains tax rates (currently 15%). Traders are also eligible for certain deductions that are not available to investors. One such deduction is the home office deduction. Traders may use their net income from trading activities to fund a SEP-IRA, and thus further reduce their taxable income. Another such deduction available only to traders is interest expense. Investors are limited to deducting interest expense incurred on debt used to finance their investment activities to investment income (gains, dividends and interest income). This limit on deducting interest expense to the extent of investment income, is not applicable to traders. Traders may deduct their interest expense as a deduction on Schedule C. Lastly, wash sale rules, which apply to investors, do not apply to traders. The wash sale rules require the deferral of trading losses, where the investor acquires substantially identical stock or securities within thirty days before or after a sale generating a loss.

So how do you make the leap once you have determined that you are in the business of trading?
Traders who desire to be treated at in the business of trading stocks make an election called the Mark-To-Market election by April15th of the current year. To be treated as a trader for 2010, a trader must make this election by April 15th, 2010, which is attached to either their 2009 Form 1040 or attached to their 2009 extension.
Election language:
Taxpayer hereby elects under IRC Sec. 475(f) to use the mark-to-market method of accounting for securities. This election will first be effective for the tax year ended December 31, 2010. The election is made for the following trades (list trades).

Once this election is made it is effective for all future tax years. The mark-to-market election requires traders to mark their stock holdings to market value at the end of the tax year. Once made, all security gains and losses are treated as ordinary income or losses and all trading securities on hand at the end of the year are deemed to be sold (and repurchased) at the year-end market value. All unrealized (unsold securities) gains and losses recognized under the mark-to-market election increase (unrealized losses) or decrease (unrealized gains) their basis in a given security.

Because making the mark-to-market election can have significant tax ramifications to future trading activities you should first consult with your CPA to determine if your trading activities meet the material participation test and, if so, if this election makes the most sense to your future trading business.

Entrepreneurs' Relief - Another Company Formation Advantage

There are many benefits of carrying out a company formation to run your new business. For those businesses with a great idea and the potential to grow their company into a large empire worth millions, there are many things to consider. Capital gains tax is one of them. For any business the future can be an exciting prospect.

You'll put blood, sweat and tears into your business and watch it grow. In the future, you want to make the most of all your efforts, without letting the taxman take a large slice. Luckily, with the current state of the economy, the government has noticed the importance of small business to the financial stability of the Country and as a result are keen to encourage growth. One of the measures they have put in place to do this is Entrepreneurs' Relief.

What is Entrepreneurs' Relief?

The Entrepreneurs' Relief scheme was originally started back in 2008 with the intention of giving some tax relief to SME's with regards to capital gains tax. An individual is given a lifetime limit (previously £1million - now raised to £2million under the new budget) under which they are given relief from capital gains tax.

What is Capital Gains tax?

Tax is charged at a rate of 18% on any capital gain made by an individual in the course of running or disposing of a business. "Capital gain" is defined by HMRC as "...the amount by which the disposal value of a chargeable asset exceeds its acquisition value." In layman's terms this means if when selling an asset you make more money than you actually paid for it, then you will be liable to pay tax on that profit at the current rate (18%).

How does Entrepreneurs' Relief help?

The Entrepreneurs' Relief scheme means that any individual making a capital gain, will not have to pay the full tax rate (18%) but instead will only be required to pay a lesser rate up to their lifetime limit. As long as they satisfy the necessary criteria.

The capital gains and capital losses must be balanced to come up with a net figure. That figure is then subject to relief, calculated thusly:

This 'net gain' is...reduced by 4⁄9 and the reduced figure is chargeable at the rate of Capital Gains Tax - 18% for 2009-10 but at an effective rate of 10%.

To clarify 4/9 is roughly 44%. So if you had a capital gain of £100,000, then you would find 44% of this figure (100,000 x 0.44 = 44,000) and that figure is then taxable at the standard capital gains tax rate, rather than the entire amount. You can see that this is quite beneficial for entrepreneurs as it provides substantial tax relief. With relief, you pay £7,920 tax on a £100,000 gain, without it you would pay £18,000! When you consider that Entrepreneurs Relief is now set to a lifetime limit of £2million you can see the Government are making a substantial subsidy for business people.

What are the qualifying criteria?

There are certain specific qualifying criteria which need to be satisfied in order to benefit from Entrepreneurs' Relief. Firstly the gain must have been made on assets used in/by the business or assets owned by the relevant person but used by the business. The claim must be submitted within a year of the disposal and apply to:

- Disposal of whole business - which the individual owned.
- Ceased business - assets sold 3 years after business ceased trading (?)
- Sale of shares of your personal company*
- Associated disposal - basically disposal from a partnership

*personal company is defined as a company in which a person holds at least 5% of the ordinary share capital (and the voting rights that go with it).

Getting there

If you've got a great idea and can see it being worth a lot in the future, then you'll need to be aware of things like this. Carry out a company formation with a formation agent and make sure you have the most tax efficient company possible. These are the first important steps to making the most of your business idea.

Tax Tips for Real Estate Investors Using IRA Funds

You've seen the advertisements and news articles. IRA funds can be used to make real estate investments. But before you jump on this bandwagon, make sure you understand some of the tax planning angles related to this opportunity.

Passive Loss Deductions

Almost always, an important component of your real estate profits comes from the tax savings associated with depreciation. These paper losses, referred to as passive losses by the Internal Revenue Code, can save both small and professional real estate investors thousands of dollars a year in income taxes. Unfortunately, passive losses from depreciation and related, similar tax deductions won't benefit real estate investors investing through IRAs.

Capital Gains Preferences

If you sell an investment for a profit--whether a stock or real estate--you get a tax break because your profit gets taxed at a preferential capital gains tax rate. In the best case scenario under current tax law, for example, your capital gains get taxed at 15% rather than at 35%.

Unfortunately, by putting real estate inside of an IRA, you lose this benefit. In effect, the appreciation you enjoy from your real estate investment gets taxed at your marginal income tax rate rather than at the capital gains rate. (Fortunately, the tax gets paid when you withdraw the money.)

Note: This "problem" also exists for other investments that produce capital gains, such as stocks and mutual funds that invest in stocks.

Unrelated Business Income Tax

In certain special circumstances, an IRA needs to pay income taxes on the profits it generates. These taxes, called unrelated business income taxes, essentially put the IRA investor in the same position as a regular taxable investor.

For example, if you're developing and then flipping properties inside your IRA, you may actually be an active trade or business. And in this case, your real estate investment--even though it's inside an IRA--may be subject to income taxes. (Your IRA custodian is supposed to report your taxable income and tax liability, and then pay the taxes but many don't...)

And here's another example of a situation where the unrelated business income tax can trip you up. If you borrow money to invest in real estate--the typical situation in any leveraged real estate investment--the profit you earn on the money you've borrowed is treated as unrelated business income. Accordingly, that profit is subject to unrelated business income tax.

Unrelated business income inside an IRA is taxed according to trust taxation rules, which means that as soon as you've made much money at all, you're taxed at the highest marginal tax rates. Ouch.

Closing Caveats

Real estate is a great investment. And real estate belongs in any investor's portfolio. But you need to think carefully about buying into the idea of using your IRA to make real estate investments. If you do decide to invest in real estate through your IRA, first consult with your tax advisor.

Capital Gains and Losses - This Year, Get it Right!

In a year in which portfolios have been decimated, it is hard to find a silver lining but controlling capital gains and losses could have significant tax consequences. As the market has declined, many investors have redeemed mutual funds and the funds needed to sell investments to meet those demands. Some of these sales may have included long-term positions in which the mutual fund may have had a significant capital gain. That means, in a year in which your mutual fund may have dropped 50% in value, you may still have significant capital gains exposure.

For retirees, that is a difficult pill to swallow. Making sure you offset these gains with losses or adjusting portfolios to take advantage of losses this year against future years gains is an important consideration. Here is a primer of what the rules are.

Capital Gains and Losses

Assets owned and then sold, or otherwise disposed of, may generate a capital gain or loss. Assets that have been held longer than one year are considered 'long-term,' while on assets held for less than a year, the gain is considered short-term. The distinction is an important one.

o The maximum tax rate for long-term capital gains is 15% for both ordinary income tax and for AMT; but long-term capital gains are preference items for calculation of Minimum Tentative Tax. Be aware that, for some investors, specifically those with lower taxable income (in 2008, $32,550 for a single; $65,100 for a married couple; and $43,650 for heads of households), tax rates on capital gains would be 0%, so the harvesting of capital losses would be wasted, since they will not be taxed on their gains anyway.

o Gains and losses on assets owned less than one year are short-term. In calculating the tax on sales of assets, a taxpayer must first net the short-term gains and losses, then net the long-term gains and losses independently. Then the short-term and long-term gains/losses are netted against one another. If a net capital loss is generated, it may be used to offset up to $3,000 of ordinary income and the unused portion (if any) may be carried forward indefinitely (expiring at the death of the taxpayer). Capital losses realized on the sale of securities may also be used to offset capital gains on other classes of assets, such as real estate and vice versa on Schedule D.

o Careful planning to harvest any capital gains or losses from sales of stock or other capital assets can minimize tax on gains and maximize the tax benefit from losses. Normally, a taxpayer should try to avoid having long-term capital losses offset long-term capital gains, since those losses will be more valuable if they are used to offset short-term capital gains or ordinary income. To do this requires making sure that the long-term capital losses are not taken in the same year as the long-term capital gains.

o Planning for the offsetting of gains and losses is not just a tax issue. As is the case with most planning involving capital gains and losses, investment factors need to be considered. The decision to wait to defer a gain until the next year needs to be balanced against the risk to the value of the property, whether its value may decline before it can be sold. Similarly, a taxpayer should not risk increasing the loss on property that he expects will continue to decline in value by deferring the sale of that property until the following year.

o Additionally, a taxpayer is permitted to identify which shares are sold during a given year as part of their transaction. These are called 'Versus Purchase' sales and allow taxpayers to identify which shares are sold to best advantage from a capital gains/loss standpoint.

o A taxpayer who owns appreciated mutual funds, which may also be good candidates for sale, may wish to consider selling those funds prior to the December capital gains payment made by fund managers to shareholders. A 15% capital gains rate is much better than having to pay ordinary income tax rates, which could be as high as 35%. There are also other advanced planning techniques which can be used to help defer the payment of capital gains tax. Please consult with your tax advisor to determine which may be best for you.

Make sure you consult your tax advisor before doing anything and consider the consequences of any portfolio adjustments on your asset allocation. In a year in which investors have suffered, you need to take advantage of what you can to improve your position for this and future years.

Tax Saving Strategies For Capital Gains on Rental Property

Have you recently sold any of your rental property? Are the taxes on your capital gains are a burden for you? Are you looking for some way out to reduce these taxes and keep most of the profits you made from this transaction?

Then you need to know some intricacies of capital gains tax rules.

If you had purchased rental property at a lower price and now sold it with a respectable margin on it, this difference you could get is the capital gain and the same is taxable.

Remember, IRS gives preference to home owners. An average home owner will be charged leniently as compared to a property investor. So the capital gains tax varies as per different types on property owners.

One good thing about the capital gains tax is that it is lower than the income tax. It is convenient if you buy the property and wait for one year before you sell it. This way you will have to pay taxes at an average rate of 10 to 25 %. But if you plan to sell your rental property before one year, then your earning is considered as short term capital gains and you have to pay heavy taxes on it which may be same as the ordinary income tax.

If you have your rental property overseas, you need to check the capital gains taxes rules over there. As in some countries like United Kingdom to encourage foreign investors, they do not charge any tax from them for their capital gains.

Some useful tips for saving on this tax:

You can avail the benefits on tax savings by becoming a home owner than a property investor.

To qualify to the criteria of home owner, you have to stay in your rental property for a minimum of 2 years. You may have rented it in past  but then you have to stay in it for two years out of five years block before you sell off. Then it will be considered as your own home for tax purposes.

If you are a married couple selling your own home, the profit of first $500,000 is not taxable as against a sole owner who is eligible for tax exemption on the first $ 250,000.

If your sale is just a rollover, you may be charged absolutely nothing towards your capital gains. So you are selling your rental property only to purchase a new property of that type, it will be a rollover.

This rollover refers to section 1031 of the internal revenue code. To satisfy the clauses of this section you have to finalize on a new property within 45 days of the sale and the deal has to be completed within 6 months.

Remember, selling your rental property in cash emergencies is not a good idea. Then it is difficult to reduce the liability on capital gains. And this is the reason why I advise property owners to put aside some of your funds for emergencies such as major repairs.