Top Five Budget Proposals We Don't Want To See Passed
Reduction
in Audits Not Entirely Good News
Spring 1999 Newsletter
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Summer 1998 Newsletter
As the Dow continues to climb, everyone’s caught up in the stock market frenzy—from those with multimillion dollar portfolios to those simply keeping an eye on their 401(k) plans. Easily overlooked are the tax implications of these transactions which, if not managed properly, can significantly reduce your rate of return. While tax planning should never dictate investment strategies, it should be part of your decision-making process.
With individual tax rates as high as 39.6%, federal income taxes can take a big bite out of your investment return. And, the recent cut in the capital gains tax has made proper tax planning even more critical.
Without considering your other investment goals or the quality of the investment itself, you generally want investments that yield long-term capital gains, taxed at a maximum rate of 20%. Your best option for these are growth stocks or growth-oriented mutual funds. Often, these are newer companies which pay little or no dividends so they can reinvest income in the company to fund further growth. Most of your return from these investments comes from an appreciated price when you sell the investment, rather than annual dividend income. While the dividends are taxed at your marginal tax rate, the profit from the sale of the investment would only be taxed at 20% if held for more than 12 months.
There’s another inherent benefit of growth stocks. You don’t pay any tax on the appreciation of the stock until you cash it in. Meanwhile, you pay tax on the dividends each year. So, with growth stocks you can get both a deferral of tax and a lower tax rate.
Of course, growth investments may have more risk associated with them than income stocks, so you’ll probably want to balance your portfolio. A good place to invest in income stocks is within a tax-deferred retirement plan such as an IRA or 401(k) plan. The dividends from these investments aren’t taxed until the funds are withdrawn from the plan at retirement. And, whether the income from those investments is in the form of dividends or capital gains, it will be taxed the same way—at your marginal tax rate.
When it comes to playing the market, timing really is everything. Not only do you need to be concerned about the stock price when you sell, but you should also look at whether selling makes sense from a tax standpoint.
The 20% capital gain rate is quite favorable, but it only applies to investments held for more than 12 months. So, unless you’re holding a really volatile stock where the bottom might drop out at any minute, be sure to hang on to it for at least a year. Even if the stock price drops a little, you may cut the taxes on the profit nearly in half if you wait.
Timing also is important at the end of the year. If you’ve cashed in some big gains during the year, review your portfolio for unrealized losses. Your stock in the asbestos manufacturing company probably isn’t going to rebound. Sell it and use the losses to offset the gains you’ve realized. And, if you end up with more losses than gains, you can use $3,000 of it against other income and carry over the remainder of the losses to next year. Always review gains and losses before the end of the year so you can offset gains and to make sure you’ve paid in enough estimated taxes to cover any gains.
Deciding when to get in or out of a mutual fund is also an important consideration. Funds usually make capital gain distributions in November or December. If you buy into a fund before the distribution date, you’ll be taxed on the gains that are distributed. Consider waiting until January to buy into the fund.
Although you don’t have control over the timing of sales inside of a mutual fund, you can look for mutual funds that consider these strategies. Some funds trade actively while others employ more of a buy-and-hold strategy. When comparing two funds with similar performance, consider the one with the lower turnover ratio. This fund will generally have fewer capital gain distributions.
A high turnover ratio doesn’t necessarily mean higher taxes. Also look at the tax-efficiency ratio. The funds that yield the highest after-tax return generally have ratios of at least 80%.
When you sell a stock, you subtract your basis (the cost of acquiring the stock) from the proceeds to determine your taxable gain. Therefore, it’s important to keep track of your basis in investments. Keeping good records will pay big dividends at tax time. You also need to consider everything that makes up your basis including:
· Fees or commissions paid when you bought the shares,
· Reinvested dividends, and
· Nontaxable returns of capital.
Consider these factors when comparing investments that achieve your desired level of return, risk, liquidity, etc., but don’t let the tax ramifications dictate your investment goals. We can help review your portfolio and find the highest after-tax return.
Two years ago, Congress simplified the tax issues concerning the sale of a principal residence for millions of taxpayers. The old rollover provision and one-time exclusion for taxpayers over 55 were replaced with a comparatively generous $250,000 exclusion ($500,000 for joint filers). While most taxpayers will satisfy the requirements, those who aren’t paying attention may be in for a shock.
To qualify for the exclusion, the following requirements must be met:
· You must own and use the property as a principal residence for at least 2 of the 5-year period ending on the date of sale, and
· You cannot use the exclusion more than once every 2 years.
For a married couple to be eligible for a $500,000 exclusion:
· One or both spouses must have owned the house for 2 years,
· Both spouses must have used the house as a principal residence during that time, and
· Neither spouse could have used an exclusion in the past 2 years.
Most taxpayers won’t have difficulty satisfying these requirements. If they do qualify, they probably won’t owe any tax because most gains won’t exceed the exclusion limit. However, unlike the old rollover rules where gain could be almost permanently deferred by purchasing a more expensive home, there is no conventional way to avoid tax for those with gains over $250,000. And, if you have been rolling over gains from previous homes, your current home may have a low-cost basis, increasing the likelihood of going over the $250,000 limit.
A number of transitional rules will be beneficial to taxpayers who sold or sell homes in 1999; 1) Any sale before May 7, 1997, did not trigger a new 2-year holding requirement; 2) The holding period and usage requirement of any house from which the gain was rolled into a new house (under the old rollover rules) is tacked onto the holding period of the new house; and 3) If the taxpayer held property on August 5, 1997, a partial exclusion will be available on any sales before August 5, 1999.
If you don’t qualify for the exclusion, you may qualify for a partial exclusion if the sale was due to a change of employment, health, or other “unforeseen circumstances.” The exclusion is based upon the ratio of days for which the requirements were satisfied to days in the 2-year period. For example, if a single taxpayer sold a home and had taken an exclusion a year earlier, he or she could exclude up to $125,000.
If all or part of the residence was ever used for business purposes or as rental property, the exclusion will only apply to the portion of the home that qualifies as a principal residence. Any gain attributable to the remainder of the home will be taxed.
EXAMPLE:
Bob sells his principal residence with a basis of $100,000 for $150,000. His home office occupied 10% of the house for the last 5 years. Without considering the impact of depreciation, Bob will have to recognize taxable capital gain of $5,000.
Even if a portion of the house is used as an office or rental property, you may still qualify for the full exclusion if that portion still meets the definition of a principal residence. For example, assume you lived in a house for 10 years and then moved into a new one. After you moved, you rented the old house for 9 months until you finally sold it. Because you met the 2 or 5-year test—the entire gain on the sale could qualify for the exclusion.
These analyses haven’t taken into consideration the impact of depreciation. Any gain attributable to depreciation taken after May 6, 1997, must be recaptured at a 25% tax rate. This gain cannot be excluded even if you have satisfied the 2-year requirement. Fortunately, the recapture is taxed at only 25%, while you may have received the benefit of depreciation deductions at tax rates as high as 39.6%. But, this demonstrates how the exclusion rules can catch someone off guard.
There are a number of instances when you may be required to calculate the gain on the sale of a residence, especially if you’ve used the home for business purposes. Therefore, it’s important to keep information that supports the cost basis of your home (closing statements, significant repairs, etc.).
And, when you decide to move, check with us to make sure you satisfy these exclusion requirements.
While Clinton’s recent budget proposals contained some modest tax breaks, some of its revenue raisers raised a few eyebrows:
1. Clinton’s proposal would deny deductions to taxpayers for tax advice related to a “tax shelter” and impose an excise tax on whomever provided that advice. The provision leaves the door open to penalize those who employ modest tax savings strategies and may inhibit practitioners from doing any proactive, or slightly aggressive, tax planning.
2. Converting a large C corporation to an S corporation would be treated as a fully taxable liquidation of the C corp, followed by a contribution of the assets to a new S corp under the new budget. Currently, such conversions are generally tax-free.
3. Under Clinton’s proposal, accrual basis taxpayers would no longer be able to use the installment method to report gains from a sale. So, if an accrual basis company sold its active business in exchange for a note, the entire gain would be immediately taxable—even if no cash had been received yet!
4. The lower-of-cost-or-market (LCM) inventory accounting method would be repealed for taxpayers with gross receipts over $5 million, causing potentially huge adjustments to taxable income and more complex recordkeeping.
5. One proposal would eliminate valuation discounts on nonbusiness property (i.e., cash and marketable securities), a key strategy for estate planning vehicles such as family limited partnerships.
Don’t panic just yet. Clinton has proposed many of these provisions before, and we’ve been spared most of them. But, it may indicate what the future holds if it becomes necessary to seriously bolster tax revenues.
IRS enforcement efforts dropped sharply during fiscal year 1998. The audit rate for all classes of individuals was one-half of 1% in 1998, less than one-third of what it was back in the early 1980s. The audit rate for individuals with income of $100,000 or more fell to 1.13%, which is one-half of its 1992 level. The Service attributes the declines to cutbacks in staffing and a higher than normal attrition rate among its more experienced audit personnel.
What does this mean to you? Well, for starters, you are clearly less likely to have your tax return audited. However, if your return is selected by the government for audit, the rules of the game have changed, and you will probably spend even more time and money resolving any disputes than you would have in the past. The use of less experienced personnel has caused the quality of audits to suffer. In addition, IRS employees are less inclined to reach a compromise solution that benefits both parties. Consequently, the chances that you will need legal assistance have increased.
After extending and re-extending the time for businesses to sign up for the Electronic Federal Tax Payment System (EFTPS), the IRS has raised the threshold for its mandatory use. Previously set at $50,000, the threshold has been raised to $200,000 in aggregate tax deposits (employment taxes, income taxes, etc.). Therefore, unless a business remitted $200,000 in tax deposits in 1998 or is apt to in coming years, it no longer has to sign up for EFTPS, or continue to use the program if it’s already signed up.
The IRS doesn’t anticipate that many businesses will drop out of the program because of its supposed ease of use. And, of course, any business may still voluntarily enroll in the program.
If you have any questions or comments contact us
at Shonsey & Associates
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