Tax Guide: After-tax Investing

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Chapter 7
Evaluate Investments
on an After-tax Basis
The Second Principle of Tax Planning

ou have fully funded your retirement accounts and you still have funds to invest. What are the tax rules that will affect your investment choices? Our federal tax system gives preferential tax treatment to capital gains and small

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business capital gains, as this chapter explains. Preferential tax treatment is also available when you invest in municipal bonds because the interest is not subject to regular federal income tax (although it might be subject to alternative minimum tax). If you buy municipal bonds that have been issued by the state where you reside, the interest is not subject to your state's income tax.

Capital Transactions

There is a 20% maximum tax rate on gains from property you hold for longer than 18 months. (There are different, more favorable rules for small business capital gains.) With the top marginal tax rate on ordinary taxable income at 39.6%, there is a significant difference in effective rates between ordinary income and capital gain income for many taxpayers.

Clearly, for 1997 and future years, looking for opportunities to generate capital gain income rather than ordinary income is an important tax-planning strategy. While considering this strategy, you also need to carefully review the economic and investment risk features of investments that can help you take advantage of the opportunities.

Tax Treatment: Securities, real estate held as an investment, and properties held for personal investment purposes are capital assets and are subject to the rules governing the taxation of capital gains and losses. To determine the tax treatment of capital gains and losses, you should group transactions involving these assets, including any loss carryovers, as long-term and short-term to determine net long-term and net short-term gains and losses. The long-term and short-term results are then netted to determine overall capital gain or loss. The maximum tax rate of 20% applies only to net long-term capital gains. If there is a net overall loss for the year, up to $3,000 of it may be deducted against ordinary income. Net losses in excess of $3,000 must be carried forward.

Generally, distributions from qualified pension and profit-sharing plans are treated as ordinary income, regardless of the source of the income inside the plan. You cannot realize a capital gains tax benefit for the capital gains generated inside a qualified plan. (Special rules govern the tax consequences of a distribution that includes appreciated employer securities for which capital gain treatment is available.) This may not change your investment strategy, as equities have historically outperformed bonds over long time periods, and you may still prefer to invest your plan assets in equities. You need to be aware, however, that the favorable capital gains tax treatment will not flow through to you when you take distributions from qualified plans.

Holding Period: Capital gains and losses are classified as long-term if they are related to capital assets held for more than the long-term holding period. (For part of 1997, the long term holding period was "more than one year." For another part of 1997 and for 1998, the long term holding period is "more than 18 months." These holding periods are discussed in Chapter 1.) Otherwise, they are considered to be short-term and are taxed at the tax rates that apply to ordinary income. A capital asset's holding period typically begins on the day after the asset is purchased and ends on the day it is actually sold. The holding period of securities purchased through a stock exchange starts on the day after the execution of the purchase order and ends on the day of the execution of the sale order. Gains and losses are generally recognized on the "trade date" (rather than on the settlement date, which is usually within three business days of the trade).

Basis: Your basis in a capital asset is generally the amount you paid to acquire the asset. In the case of a gift of a capital asset, basis is generally the same in the hands of the donee as it was in the hands of the donor, potentially increased by a portion of any gift tax paid. (There is an exception where the fair market value at the time of the gift is less than the asset's basis. In that case, for purposes of determining loss on the ultimate sale of the property, basis is generally considered to be equal to the fair market value at the time of the gift.) In the case of assets acquired by inheritance, the recipient's basis is equal to the fair market value at the date of death (or the alternate valuation date, if this date was elected for estate tax purposes). In either case, gain or loss is not recognized until the asset is sold.

For property acquired by gift, the holding period includes the time the asset was held by the donor. For property acquired from a decedent, the long-term holding period requirement is automatically considered to be met.

Small Business Capital Gains: A noncorporate taxpayer who holds qualified small business stock for more than five years can exclude 50% of any gain on the sale or exchange of the stock. The amount of gain eligible for the 50% exclusion is limited to the greater of (1) 10 times the taxpayer's basis in the stock or (2) $10 million of gain from the disposition of that stock. The balance of the gain, if any, is subject to a maximum rate of 20%. One-half of the gain that is excluded is treated as an alternative minimum tax preference item.

Rollover of Gain from Sale of Publicly Traded Securities: Any individual or C corporation can elect to defer recognition of the capital gain, subject to certain dollar limitations, realized on the sale of publicly traded securities if the individual or corporation uses the proceeds from the sale within 60 days to purchase common stock or a partnership interest in a specialized small business investment company. A specialized small business investment company is any partnership or corporation licensed under section 301(d) of the Small Business Investment Act of 1958. For most individuals, the amount of the gain that can be rolled over in one tax year is limited to the lesser of $50,000 or $500,000 reduced by previously deferred gain. For C corporations, the numbers are $250,000 or $1,000,000.

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Passive Losses

Passive losses can't be used to reduce nonpassive income, such as wages, dividends, and interest, except in limited circumstances. Passive losses are defined to include losses from all rental activities and any other businesses in which the taxpayer does not "materially participate." Most investments in partnerships by limited partners are also deemed passive. These rules effectively elim-inate the tax benefits of investments viewed by Congress to be "tax shelters."

Conclusion

The relatively favorable tax treatment given to capital gains as compared with ordinary income is a significant incentive for you to invest in assets that will produce maximum capital gain income, instead of ordinary income (such as interest and dividends).

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