Tax-Free Capital Gains for Some

The stock market’s rebound from its nadir in March 2009 means many investors are back in the money. And some them will owe no tax on the profits they cashed in last year when they file their 2010 tax return this spring.

Normally, capital gains and qualified dividends are taxed at a maximum rate of 15% -- a bargain compared with the top income tax rate of 35%. But for 2010 (and through 2012), investors in the two lowest income tax brackets will pay no tax on their capital gains and dividends.

Timing matters

To qualify for preferential capital-gains treatment, you must hold shares of your stocks or mutual funds for more than a year before selling. (This applies to assets in taxable accounts, but not those in retirement accounts. Profits inside a tax shelter are not taxed when the gains are realized, but are taxed at your ordinary rates upon withdrawal.) Short-term capital gains on assets held less than a year are taxed at a maximum 35%.

To figure your tax liability on your investments, you must first match any short-term gains with short-term losses and long-term gains with long-term losses. If, after netting capital gains and losses, you are left with a capital gain, it is taxed at a maximum 15% -- or, depending on your tax bracket, 0%.

But if you are left with a loss, you can use it to offset up to $3,000 of ordinary income, such as wages, and carry forward excess losses to future years. The key is that the loss must be real, not just a paper loss, in a taxable account. Losses in a retirement account, such as an IRA or 401(k), generally can’t be used to reduce ordinary income.

Tax-free gains

To take advantage of the 0% capital-gains rate for 2010, your taxable income can’t exceed $34,000 if you are single; $45,500 if you are a single head of household with dependents; or $68,000 if you are married filing jointly. Note that this is taxable income. That’s what’s left after you subtract personal exemptions -- worth $3,650 each in 2010 for you, your spouse and your dependents -- and your itemized deductions or standard deduction from your adjusted gross income.

The standard deduction for 2010 is $5,700 for individuals; $8,400 for heads of households; and $11,400 for married couples. Plus, there’s an added standard deduction of $1,100 per person for married individuals 65 or older and $1,400 for single filers 65 or older.

Any gains that lift your income above that threshold would be taxed at the maximum 15% capital-gains rate.

Likely candidates to benefit from the 0% tax rate include retirees, who have a higher standard deduction than younger taxpayers and who are not taxed on some of their Social Security benefits, and the unemployed, who may have had to tap their investments to make ends meet.

One group of taxpayers who won’t benefit from the zero capital-gains rate are children affected by the “kiddie tax.” Dependent children under 19 and full-time students under 24 are affected by the special rule that applies their parent’s higher tax rate to investment income they received in 2010 in excess of $1,900.

Advice for fund investors

If, like most investors, your mutual fund dividends are automatically used to buy 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. Forgetting to include the reinvested dividends in your basis results in double taxation of the dividends -- once when you receive them 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.