A Little Planning May Save You Lots of Taxes!

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Spring is here, and while I am chomping at the bit to go outside and dig in my flower beds, the specter of the April 17 IRS tax deadline is keeping me chained to my desk! 

As much as I absolutely love making money with my investments, I loathe taking the time each year to sit down and calculate my various capital gains and losses and - at the same time - figure out how to minimize the taxes on my profits. And I know most investors feel the same way.  

Consequently, I thought you might be able to use some solid tips to help you wade through the minefield of tax information to determine the optimum strategy for keeping the taxes on your investment gains to a minimum. In these pages, I will touch on a few tax situations that often drive investors into a frenzy at tax time. 

First, let's talk about calculating the cost basis of your investments. Those two simple words strike fear into the heart of many investors. And no wonder - with all the stock splits, spin-offs, takeovers and reinvested dividends to keep track of - recordkeeping can be a nightmare. Alternatively, if you start out right and keep simple records, you can sail through your tax return. Here's what you need to know... 

The cost basis of an investment is simply this: its original value adjusted for stock splits, dividends and capital distributions. You must know this basis in order to calculate any capital gains or losses for tax purposes. If you sell a security for more than its cost basis, you will have a capital gain. And likewise, if you sell a security for less than its cost basis, you will incur a capital loss. 

At its most basic level, cost basis is equal to the total amount you invested plus any commissions you paid for the transaction. However, life is seldom that simple. And you must adjust the cost basis for subsequent stock splits, takeovers, spin-offs and reinvestment of distributions.  

The IRS provides for several alternative methods for calculating the cost basis of an investment.  

For individual stocks, investors may select 1 of 2 options: 

1. FIFO, or first in, first out. In this method, the first shares you purchased are considered the first shares redeemed. If you do not specify a method, the IRS will assume you used FIFO. However, FIFO seldom provides the most optimum tax treatment. For instance, your oldest shares will often also be your most profitable ones. And if that is the case, you will incur higher taxable gains by designating the sale of your oldest holdings first.
2. Specific identification requires that you specify the exact shares that you are selling, which must be confirmed, in writing, by your broker (which he can do by adding a memo line on your confirmation statement). This method allows a little more flexibility in determining your tax liability.

For mutual funds, investors have a few more options: 

1. FIFO
2. Specific identification
3. Average cost requires that prior to your first partial sale you add up the cost basis of your entire position, then divide by the number of shares you own, to arrive at an average per-share cost. This strategy generally will give you a better result, tax-wise, than using FIFO. The IRS presumes that you are selling your oldest shares first. One important note with this method: once you have selected the average cost method, the IRS will not allow you to switch to another cost basis calculation method without its permission. Fortunately, most mutual fund companies and brokerage houses will help you with this by maintaining an ongoing calculation of average cost, including the automatic reinvestment of any distributions.
4. Average cost double category is complex and rarely used, but allows you to calculate the average cost in two different capital gains brackets, short-term and long-term. Please see the IRS link below for a detailed explanation.

As well, special rules apply for calculating cost basis on bonds and on gifts or inheritance of securities, so please refer to the IRS for details:  

http://www.irs.ustreas.gov/pub/irs-pdf/p550.pdf 

Long-term investors received a very nice gift with the changes in the 2003 tax laws, which significantly reduced the taxes owed on investments held longer than one year.  

These gains are now subject to long-term capital gains taxes - with a maximum tax of 15% (for investors in 25% or higher tax brackets) for 2006 - rather than the higher, ordinary income tax rates that had previously been applied (maximum of 35% for 2006). And if you are a taxpayer in the 10-15% tax bracket, your long-term capital tax gain rate is just 5%. 

These favorable rates were due to expire in 2008, but legislation enacted in 2006 extended them through 2010. 

Now, if you hold your investments less than one year, any gains will be considered short-term capital gains and will be taxed at your ordinary income tax rate. 

If, on the other hand, your capital losses exceed your capital gains, the excess is subtracted from your other income up to an annual limit of $3,000, or $1,500, if you are married, filing separately. 

In order to take maximum advantage of this nice gift, you must save your brokerage confirmations and statements, indicating the price you paid for your investments and when you purchased them. And for mutual funds, you should also save all statements that show any automatic reinvestment of distributions into additional shares. 

For additional information, please see: http://www.irs.gov 

Like long-term capital gains, ordinary dividends also benefited from the 2003 tax legislation, also incurring the maximum 15% tax rate. But there is a stipulation: you must have held the security for at least 60 out of the 120 days beginning 60 days prior to the ex-dividend date (if you bought the security on or after this date, you do not receive the dividend). Otherwise, your dividends will be taxed at your regular income tax rate.  

Real Estate Investment Trusts (REITs) are required, by law, to pay 90% of their exempt rental income out in distributions to their unit holders. For tax purposes, these distributions are allocated to ordinary income, capital gains and return of capital - all of which may be taxed at a different rate.  

A return of capital distribution is not taxed as ordinary income; instead your cost basis is reduced by the amount of the distribution. Then, when you sell the security, you will be subject to a capital gains tax on the excess of the net sales price over the reduced tax basis. 

Since REITs are not usually subject to corporate taxes, the majority of their dividends are taxed at ordinary income tax rates. However, they may qualify for a lower tax rate if the following conditions are met: 

1. When you are subject to a lower scheduled income tax rate
2. When a REIT makes a capital gains distribution (15% maximum tax rate)
3. When a REIT distributes dividends received from a taxable REIT subsidiary or other corporation (15% maximum tax rate)
4. When allowed, and a REIT pays corporate taxes and retains earnings (15% maximum tax rate)

Additionally, the maximum 15% capital gains rate usually applies to the sale of REIT stock.  

Your REITs will send you a 1099 each year, indicating the allocation of their distributions between ordinary income, return of capital and capital gains. 

Available data from NAREIT, the trade organization, reports that in 2005, 44% of REIT dividends qualified for the 15% capital gains rate. Of those, 36% were related to capital gains distributions and 64% to return of capital, taxed at a capital gain rate upon sale of the stock. 

For additional information, please refer to: http://www.investinreits.com 

Publicly traded partnerships, often called Master Limited Partnerships (MLPs) are similar to REITs, in that they are also pass-through securities, passing 90% of their income to their unit holders. 

The 1987 tax code limited MLPs to those operating in the energy, timber or real estate-related industries. However, the code grandfathered in MLPs that were already trading, allowing them a 10-year transition period. But that period was then extended indefinitely under the Taxpayer Relief Act of 1997 for those MLPs who elected to pay a small 3.5% tax on their gross income from their partnership activities.  

There are presently some 50 publicly traded partnerships, mostly in energy, natural resources and real estate. But I know of an amusement park operator and a macadamia nut grower who also claim MLP status. 

Like REITs, these MLPs are taxed just on one level - the unit holders. Therefore, most dividends are not considered qualified or eligible for the lower, 15% tax rate, and are instead taxed at your ordinary income tax rate. 

However, cash distributions are taxed differently, treated as a return of capital, which reduces your cost basis. Additionally, the partnership's allocation of deductions such as depreciation and losses will also reduce your cost basis. Likewise, income allocations will increase it. 

Investors are not taxed on distributions until:

1)      they sell their units, or

2)      their cost basis reaches zero

When you sell your units, the difference between your sales price and adjusted cost basis may result in a capital gain, and be subject to capital gains taxes, but the portion of the gain that results from a downward adjustment of the basis after allocation of depreciation or other deductions may be taxed at the ordinary income rate. 

One important note: an MLP investor will be taxed on his share of the partnership income regardless of whether he actually receives any cash from the partnership. 

And instead of receiving a 1099, partnership investors will receive a K-1 form indicating gains, losses, deductions and credits. If these result in net income to you, you will be taxed at your individual tax rate. Net losses will be considered passive losses and may not be used to offset income from other sources; they must be carried forward and offset against future income from that particular partnership. 

For additional information, please see: http://www.naptp.org 

I hope this information will give you a little help as you prepare your IRS tax forms this year. But remember, I am not a tax accountant or attorney, so for the rules regarding your exact personal situation, please obtain professional assistance. And best of luck with reducing that beast of burden! 

About the Author
Nancy Zambell, Contributing Editor to BrokerAdviser.com's Financially Fit, has enjoyed a diversified career in the financial services industry. Read More

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