Investing and Backdoor Taxes

It’s been a pretty good year so far for the stock market, and you may have locked in some nice capital gains on investment sales, and/or received some hefty dividends from mutual funds (or may yet receive year end fund distributions). While all of this is good stuff (more money in your pocket), the additional gains and income could put you in the position of paying even higher taxes than you may anticipate.

In my practice, this past tax season was a “perfect storm” for a bunch of my clients, who got hit with additional/higher taxes, as well as the loss of various deductions. Let me run down a few things from last year that are still lurking out there this year.

Net Investment Income Tax – this was a new tax in 2013, and is a 3.8% tax on income such as capital gains, dividends, interest, and a few other items. Once income goes above certain levels, this additional tax will kick in.

Personal Exemption Phaseout – while this isn’t an additional tax per se, the fact that personal exemptions (for self, spouse, dependents) can be reduced literally to zero if income is high enough, which has the effect of raising taxable income, obviously creating a higher tax.

Itemized Deduction Phaseout – this works similarly to the exemption phaseout, in that when income is high enough, itemized deductions will be reduced. And as with the exemption phaseout, this exposes more income to taxation.

Higher Long-Term Capital Gains Rate – for taxpayers in the top tax bracket, long-term capital gains will be taxed at 20% and not 15% for most other taxpayers.

Alternative Minimum Tax – I’ve covered this in previous articles, but it’s something that’s also still hanging around, and shouldn’t be forgotten.

From a tax planning perspective, if you feel some or all of these could be applicable to you in 2014, and you don’t want surprises at tax time, I recommend that you contact your favorite CPA (maybe one whose name starts with “Jay The…”?) to crunch some numbers and get some additional guidance on ways to reduce the sting of some of these stealth taxes.

Home Sales and Taxes

With the housing market as hot as it’s been, you may be thinking of selling a home, and hopefully taking the profit and running. But will you owe any taxes to Uncle Sam? The short answer is, it depends (hey, nothing’s ever straightforward when it comes to taxes!) This article will discuss various aspects of home sales and taxes.

Principal Residence?

If the home being sold is your principal residence, up to $500K of gain on the sale can be excluded from tax on a married joint return ($250K for a single taxpayer). Note that this is gain on the sale, which is generally the difference between the selling price and the cost basis of the home. Also remember that this is for the place that you call home, normally your primary residence, and not a second or vacation home. The exclusion can be claimed if you’ve lived in this residence for at least two of the previous five years. If you don’t meet the two year requirement due to certain specific unforeseen circumstances, a reduced exclusion can be available.

Rental Property?
Do you live in a home that’s also partially rented out to somebody else? If you do, the two parts (residence and rental) need to be split into two transactions for tax purposes, and only the residence part is subject to the gain exclusion. Any gain on the rental portion will be 100% taxable.

3.8% Medicare Tax

For tax years starting in 2013, there’s a 3.8% Medicare tax on “net investment income”, and I’ll give you one guess what gets included in this computation. The good news is that if the principal residence exclusion amount wipes out your gain on sale, you won’t be subject to the 3.8% tax either.

Sale of Principal Residence at a Loss

Sorry, this one just isn’t deductible, period, end of story. The story has a different ending if it’s a property you rented out to others, but that’s beyond the immediate scope of this article.

Home Office Depreciation

If you took depreciation deductions on a home office, this will reduce the basis of your home, for purposes of computing the gain on sale. Not only that, but the amount of depreciation taken in previous tax years will be recaptured on sale as taxable income, and also be subject to the 3.8% Medicare tax.

Obviously there are lots of non-tax related things to think about when selling a home (moving, for one), but don’t lose sight of the tax laws surrounding the sale, because if you do, you may have a nasty surprise come tax time. My recommendation is to speak with your favorite CPA (hint hint) and do some pre-sale tax planning.

Please forward this article to anybody you know who is considering selling a home, and if you have any personal stories or comments about home sales and taxes, please leave a comment.

A Capital Idea…Gains and Losses

Now that we’re in the thick of tax season, I want to briefly discuss a topic that affects many taxpayers in this country, capital gains and losses. In my 11/7/11 post, I wrote briefly about the new reporting requirements for both brokers/mutual funds, and taxpayers. In this article, I’d like to discuss in a little more detail exactly what constitutes capital gains or losses.

Did you know that almost everything you own and use for personal purposes, pleasure, or investment is considered a ‘capital asset’ for tax purposes? Well now you know (that, and $2.50 will get you on the NYC subway!) Capital assets include a home, household furnishings, and stocks & bonds, among other things.

When you sell a capital asset, the difference between what you paid for the asset (its basis) and its sales price is capital gain or capital loss. Here’s the fun part…you must report all capital gains. Now here’s the bad part…you may only deduct capital losses on investment property, not on personal-use property. What this means is that you can deduct the loss you had on the sale of your Worldcom stock, but you can’t deduct the loss on the sale of your Ford Pinto.

Capital gains and losses are classified as long-term or short-term, and this is important, since the tax rate on long-term gains is generally 15%, while short-term gains are taxable at your marginal tax rate, which can go as high as 35%. In order to be classified as long-term, the capital asset must have been held more than one year (e.g. a year and a day, or more).

All capital gains and losses are netted out to figure out what needs to be included in your taxable income. If everything nets out to a loss, you can deduct the excess losses on your tax return to reduce your other income (wages, interest, dividends, etc), but there’s an annual limit of $3,000 that can be used. For the unfortunate taxpayers who had huge losses on stocks from the last market crash, the excess of the $3,000 that can be deducted annually can be carried forward and applied in subsequent tax years until used up. If, in subsequent years you have capital gains, the losses that were carried forward can be applied against the capital gains, dollar for dollar.

As I mentioned in my 11/7/11 article, IRS created Form 8949 which must be used starting with 2011 returns, to report capital gains and losses. The totals on the 8949 forms then get carried over to Schedule D, and ultimately on to the 1040.

I hope this helps with your understanding of capital gains and losses, if you were fuzzy about them previously. I welcome any comments you may have on this subject, and please pass along this article to friends, enemies, colleagues, or somebody who could use some extra tax knowledge on what might otherwise be a mundane day!