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Year End Tax Planning-Avoid Tax on Phantom Capital Gains
Although the information discussed herein may or may not apply to you, depending on your situation, and should not be considered tax advice which should be sought from your personal tax professional based on your individual facts and circumstances, it is food for thought based on situations that I have experienced and witnessed in prior years and throughout my career as a tax professional. One factor which you need to discuss with your tax professional along with your financial advisor is the fact that under current law during years 2008-2010, taxpayers in the 10% and 15% tax bracket pay a 0% tax on capital gains; however this benefit is not available to those in the 25% tax bracket which begins when taxable income reaches $65,100 for married taxpayers filing a joint return, $43.500 for those who qualify as head of household and $32,500 for single taxpayers and those who are married but file a separate return from their spouse. Another consideration for those who do not qualify for the 0% capital gains rate is the Alternative Minimum Tax (AMT). I recently came across a pretty good article on year end tax planning; however I can't stress enough that tax planning should be done with the help of your tax professional. The link to this article is www.nysscpa.org/cpajournal/2006/1206/essentials/p40.htm, however as this article was written a while ago it does not consider recent changes to the tax law as well as those to the "kiddie tax".
How Mutual Funds are Taxed
If you own mutual funds you need to comprehend the tax consequences involved. If the funds are not held within a qualified tax deferred account such as a traditional or Roth IRA or employee 401 or 403 plan, they are subject to tax based on the activity within the fund based on the actions of fund managers and not by you. When investing in a mutual fund, you decide which fund to invest in and the fund manager decides how to invest your money, so you own a proportionate percentage of all the diversified investments of the fund, which could be common stock in corporations, bonds, etc. When the stocks owned by the fund pay dividends, you are taxed on your proportionate share of the dividends. When the fund manager decides that it is time to sell certain securities held by the fund and reinvest your money elsewhere, you are taxed on your proportionate share of any capital gains resulting from the sale, which is determined by the spread between the amount that the securities were sold for and the tax basis (adjusted cost) of the fund. It has nothing to do with the amount you invested in the fund or the value of the securities at the time of your investment. Thus, if you invested in a mutual fund in year 20xx and the fund was formed in 20yy, the certain underlying securities held by the fund may have appreciated in value in 2008 and the fund manager may have decided to sell these securities in 2008 which triggers a TAXABLE long term capital gain to you. So for 2008, the fund will issue you a "Form 1099" reporting your share of dividends and capital gain distributions that must be reported on your tax return and on which you will pay tax. Intrinsic capital losses realized within the fund are not reported and you receive no tax benefit or deduction.
The Worst Possible Scenario
Most registered representatives and many financial advisors suggest that people who invest in mutual funds elect to have capital gains and dividends reinvested into the fund and not withdraw any cash from these activities. The theory is that by leaving the money in the fund it will compound and as the fund value increases, you will own more units and make more money. But what if the market tanks as it did in 2000 and again this year in 2008, and your total account value, which includes reinvested taxable capital gains and dividends, is now worth less than your original investment. Does this mean that you do not have to pay tax? ABSOLUTELY! Even though the value of your mutual fund has declined significantly, you are subject to tax on all dividends and capital gains earned by the fund during the year, even though you lost money "on paper".
To make this clear, I will discuss what I saw happen to many people back in 2001 when they came to me to prepare their income tax returns. During the early days of year 2000 many stocks were peaking, some at inflated amounts. As these stocks may have been purchased when the price was much less (and often split causing a decrease in tax basis), they sold the stocks and triggered sometimes substantial capital gains for the fund holders. Some of these clients were overjoyed that their investment value was increasing while others never read their statements. But what happened at the end of 2000 stock prices were on the decline and when these clients prepared their income tax returns in early 2001, even though their mutual fund value had substantially declined (sometimes below their original investment) they were taxed on the capital gains recognized by the funds in early 2000.
To some this was a disaster. They had to pay significant income tax on from the capital gain distributions that were reinvested into the fund, money that they lost but could not declare as a capital loss until the fund units were sold. Some were forced sell units from the same mutual fund in order to pay the income tax in 2001 and this resulted in a long term capital loss for income tax purposes. But one of the most unfair tax provisions (in my opinion) is that individuals cannot carry back capital losses to offset capital gains from prior years and without future capital gains, can only deduct $3,000 each year going forward.
My Prediction for 2008 is that we will see this happen again and for those who own mutual funds (or individual stocks which they purchased with money from capital gains after selling stocks earlier in the year), the time to begin your 2008 tax planning is NOW!
How to avoid paying tax on phantom gains
If the situation described reflects you, the one way to avoid paying capital gains tax on money that you ultimately lost (as described above) is to 1) examine all your statements and add up all your reinvested capital gains to determine what your taxable capital gain distribution will be (as well as reinvested dividends) and estimate how much tax you will owe. Then check the trading price of the mutual fund units and compare it to what you invested originally and divide that by the original amount of units purchased to determine the cost basis for the fund units originally purchased. Your basis in units (or partial units) purchased from reinvested dividends and gains should be stated on each statement you received.
The bottom line is if the value of the fund NOW is less than your investment, you have a capital loss, and if you will end up paying tax on the underlying income of the fund (I.E. 2008 capital gain distributions and dividend income), it MAY (depending on your personal situation) be a good idea to sell your mutual fund units BEFORE DECEMBER 31, 2008 in order to recognize the capital loss this year when (and if) you need it.
When the market recovers you can always reinvest your money in the same or similar fund (depending on the fund's rules). BUT BE CAUTIOUS OF THE WASH SALE RULE! The wash sale rule prevents a taxpayer from claiming a loss on the sale of a security if the same security that was sold is purchased 30 days before or after the sale! So if you sell to recognize the tax loss but want to reinvest immediately, be sure not to buy the same security that you sold.
If your loss exceeds your gains you can carry them forward and offset them against future capital gains. If after the sale you still have taxable gains and dividends and will need money to pay the remaining tax, be sure to budget this if you you plan to reinvest your money in the market. Another factor to consider in generating capital losses is that they may be worth more to you in the future if you continue to invest as it is probable that the capital gains tax rates will be higher in future years, and offsetting future capital gains with capital losses carried forward may save you money as well.
One final note. If you are going to sell this year, don't wait until the last week. Beside there being an increased likelihood that others have the same plan which would put more pressure on stock prices during the last weeks of the year, you don't want to risk the possibility that your fund may possibly report the sale as a 2009 transaction.
OTHER TAX CONSIDERATIONS
Although existing law does not tax capital gains at lower rates, this does not mean that it will not be changed. Therefore I would not overlook an opportunity to sell stocks and mutual funds in 2008 when the market is low to trigger losses which can be carried forward. Should you reinvest at the right time and sell when the market recovers, you may have a substantial capital gain in the future which could be offset by the loss carried forward. This capital loss carryforward could also be used to offset gains from selling property inherited in 2010 when the tax basis of inherited property is scheduled to be replaced with a donor carry over basis from the existing fair market value. Again, planning is the key and should be done with your tax professional and your financial adviser.
The IRS Offers Valuable Advise for Making and Deduction Charitable Donations Please click and read. Unless these guidelines are followed I cannot, as your tax return preparer, deduct donations made to charity.