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Valuable Year End Tax Planning Strategies for Investment Assets

By: Richard Feldman

By: Richard Feldman, CFP, AIF, MBA

The end of the year has snuck up on us once again, so, it is time for me to discuss year end tax saving strategies. The equity markets are closing out another positive year bringing the total to four straight years of positive gains. This means that investors can expect larger year end capital gain distributions from the mutual funds they own in taxable accounts. Distributions should be particularly large in asset classes that have fared best, such as domestic small cap value and international small and large cap value, as well as emerging markets. Increased capital gains distributions will mean an increased tax bill for investors. Individuals should look through their brokerage statements to see if they can take advantage of the following strategies to reduce the tax burden owed to Uncle Sam.

Tax-Loss Harvesting

Investors who have taxable accounts should look at their portfolio every December and see if there are any capital losses that might be realized. Selling your losers or booking tax losses now can help you offset the future tax liability created when you sell an investment at a gain. Investors in high federal and state tax brackets should try and offset short term gains if possible. Short Term capital gains are taxed at an investor’s ordinary income tax bracket which can be as high as 35%. Long term gains on the other hand enjoy the benefit of being taxed at a 15% tax rate. Typically short term gains and losses are netted against one another and the same thing for long term gains and losses. After the initial netting of short and long term losses the two are than netted against one another which will leave you a short term or long term gain or loss. Again it is beneficial to try and end up with a long term gain rather than short term gain due to the disparity (up to 20%) of the tax rates on short and long term gains. If you end up with a loss, either short or long term, $3,000 of that loss can be used to offset ordinary income. A $3,000 loss will save you approximately $840 in taxes assuming you are in the 28% bracket.

Share Identification

Tax loss harvesting might also be used for an investment that has different tax basis or lots. Individuals might have purchased securities at different times and depending on the price may have a gain in one or a loss in the other. In situations like this you can use a method called lot identification or “versus purchase”. Typically, this is done by telling your financial advisor or broker that you would like to sell a specific tax lot rather than the usual accounting method of average cost. Your trade confirmation should show that the shares were sold versus the specific lot you had purchased on a certain date.

Wash Sale Rule

Make sure your tax-loss selling conforms with IRS guidelines known as the “Wash Sale Rule” which will disallow a loss deduction when you recover your market position in a security within a short time before or after the sale. Under the Wash-Sale Rule, a loss deduction will be disallowed if within 30 days of the sale you buy substantially identical securities or a put or call option on such securities. The actual wash-sale period is 30 days before to 30 days after the date of the sale (61-day period). The end of a taxable year during the 61-day period still applies the wash-sale rule, and the loss will be denied. For example, selling a security on December 25th of 2004 and re-purchasing the same identical security on January 4, of 2005 will disallow a loss.

Carry Forwards

Assess your gains and losses. Individuals should look at Schedule D of their tax return in order to determine if they have any carry forwards that could offset any potential capital gains distributions or sales that might create a gain. Individuals who have a loss carry forward should still harvest any losses if possible. These losses may offset any future gains that are made in the stock market o real estate as well.

Year End Capital Gains Distributions

Mutual fund investors need to be careful when purchasing funds at the end of the year. Mutual funds by law are a “pass through entity”, which means the tax liabilities they incur from investments pass through the fund and on to the shareholder. Funds must pay shareholders 98 percent of the dividends and capital gains. Make sure you check the fund company’s estimates of dividends, short term-gains, and long-term gains before you buy them at year end in a taxable account.

Gift Appreciated Assets

Thanks to President Bush, it is more appealing than ever to gift appreciated assets. Giving highly appreciated assets to someone in a lower tax bracket or charity can effectively reduce or eliminate taxes entirely and remove the asset from your estate. Due to the new tax laws, if you gift a highly appreciated security to an individual in the 10% or 15% bracket they will only pay 5% capital gains taxes on the appreciation. Under current tax laws if the donee (the recipient of the donation) keeps the asset until 2008 and is still in the 10% or 15% tax bracket there will be no taxes due. The one issue you want to make sure of when gifting to children is the Kiddie Tax rule. The last tax Act increased the age to 18 from 14 for children when qualifying for the Kiddie Tax. Make sure you check with your accountant or CPA when gifting stock to children so that you do not run afoul of the Kiddie Tax laws.

Summary

One of the biggest drags on investment performance is taxes. For taxable investors, proper year end tax planning will allow you to keep more of your investment return and pay less to the government. Tax loss harvesting has become easier due to the increased number exchange traded funds (ETFs). It is now much easier to maintain the integrity of your investment portfolio by using ETFs for the proceeds of trades made to book tax losses.