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All Contents © 2016The Kiplinger Washington Editors
Because federal tax law reaches deep into all aspects of our lives (as well as our pockets), it's no surprise that the rules that affect us change as our lives change. This can be particularly advantageous (or threatening) to investors. Different investments can be treated in vastly different ways by the Internal Revenue Service. As portfolios change over the years, so do the rules that apply. Being alert to the shifting landscape is the key to holding down your tax bill.
By Kevin McCormally, Chief Content Officer
, February 2016
Long-term capital gains (the profit from the sale of assets owned more than one year) and qualified dividends enjoy special tax rates, ranging from 0% to 23.8%, compared with the 10% to 43.4% bite that applies to other kinds of income.
But in order to take advantage of the special rates, you have to use a special worksheet to figure your tax bill (or use a computer program that does the work for you). Use either the 27-line Qualified Dividends and Capital Gain Worksheet in the Form 1040 Instructions or the 30-line Schedule D Worksheet in the (you've got it) Schedule D instructions. If you simply go to the tax-rate tables, you’re sure to overpay the tax on your investment income.
At Kiplinger, we call this the Angel of Death tax break. The tax basis of most assets you inherit is stepped up to the property's value on the day the owner died. (An exception to this rule applies to retirement accounts.)
Since the basis is the amount from which gain or loss is figured when you sell an asset, this means that the tax on any appreciation prior to the death is forgiven. Say, for example, that an uncle had stock in a brokerage account for which he had paid $10,000 but was worth $100,000 when he died and left it to you. Your basis would be $100,000. Only if you sold the stock for more than that would you owe any capital gains tax. If you sold it for less than $100,000, in fact, you would have a tax-saving capital loss. The government says this provision will save taxpayers who sold inherited property during 2015 more than $32 billion when they file their returns this year. Be sure to get your share of the savings if you sold inherited assets.
SEE ALSO: States with the Scariest Death Taxes
If, like most investors, your mutual fund dividends are automatically reinvested in extra shares, remember that each reinvestment increases your tax basis in the fund. That, in turn, reduces the taxable capital gain (or increases the tax-saving loss) when you redeem shares in a taxable account. Forgetting to include reinvested dividends in your basis results in double taxation of the dividends—once in the year they are paid and reinvested and later when they're included in the proceeds of the sale.
Don't make that costly mistake. If you're not sure what your basis is, ask the fund for help. Funds often report to investors the tax basis of shares redeemed during the year. In fact, for the sale of shares purchased in 2012 and later years, funds must report the basis to investors and to the IRS.
SEE ALSO: The Power of Reinvested Dividends
Investors are sometimes tripped up by a provision of the law that says that the basis of investment real estate must be reduced each year by the amount of depreciation "allowed or allowable." In other words, even if you don't claim depreciation, you're supposed to reduce your basis. That's a problem because a reduced basis usually means more taxable profit when you sell. So, not understanding the rules while you own a rental property could come back to bite you when you sell it.
But the IRS has a heart. Qualifying taxpayers can file a Form 3115, Change in Accounting Method, for the year of the sale. That lets you deduct the allowable-but-unclaimed depreciation from earlier years to offset the phantom profit triggered by the reduced basis. If you're caught up in the "allowed or allowable" trap, be sure to see if Form 3115 can set you free.
Generous investors need to think twice before writing a check to their favorite charity
Rather than cash, consider donating appreciated stock, mutual fund shares or other assets you have owned more than one year. Doing so lets you deduct the full market value of the asset on the day of the gift, but neither you nor the charity ever has to pay tax on the gain that accrued while you owned the asset. It's a win-win. If you gave away appreciated securities in 2015, make sure you get the benefit of your supercharged deduction.
SEE ALSO: 5 Things You Should Know About Giving Stock to Charity
In 2015, the IRS found another court that agrees with its tough stand on the issue of demutualized stock. That's stock that a life insurance policyholder receives when the insurer switches from being a mutual company owned by policyholders to a stock company owned by shareholders. The IRS's longstanding position is that such stock has no tax basis, so that when the shares are sold, the taxpayer owes tax on 100% of the proceeds. In 2009 and again in 2011, federal courts sided with taxpayers who challenged the IRS position. Late in 2015, though, a divided federal appellate court ruled in favor of the IRS. Sooner or later, the Supreme Court may have to settle things.
In the meantime, if you sold stock in 2015 that you received in a demutualization, you have a couple of choices. Claim a basis and, if the IRS rejects your position, file an appeal. Or use a zero basis, pay the tax on the full proceeds of the sale and then file a "protective refund claim" to maintain your right to a refund if the matter is eventually settled in your favor.
If you purchased a taxable bond for more than its face value—as you might have to capture a yield higher than current market rates deliver—Uncle Sam will effectively help you pay that premium. That's only fair, since the IRS is also going to tax the extra interest that the higher yield produces. You have two choices about how to handle the premium:
Option 1: You can amortize the premium over the life of the bond by taking each year's share of the premium and subtracting it from the amount of taxable interest from the bond you report on your tax return. Each year you also reduce your tax basis for the bond by the amount of that year's amortization.
Option 2: Or, you can ignore the premium until you sell or redeem the bond. At that time, the full premium will be included in your tax basis so it will reduce the taxable gain or increase the taxable loss dollar for dollar.
The amortization route can be a pain, since it's up to you to both figure how each year's share and keep track of the declining basis. But it could be more valuable, since the interest you don't report will avoid being taxed in your top tax bracket for the year—as high as 43.4%, while the capital gain you reduce by waiting until you sell or redeem the bond can't be taxed at more than 23.8%.
If you buy a tax-free municipal bond at a premium, you must use the amortization method and reduce your basis each year but you don't get to deduct the amount amortized. After all, the IRS doesn't get to tax the interest.
SEE ALSO: The Best Bonds for 2016
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