Capital gains and losses are areas that offer great tax planning opportunities, since in many situations, you control when the gains and losses will be realized.
Many taxpayers have incurred losses on stocks and mutual funds and selling them now can allow them to realize the loss and reduce their tax liability. Capital losses can be currently deducted to the extent of capital gains plus $3,000.
Any nondeductible losses are carried over to future years.
Sometimes taxpayers will want to maintain their investment in a stock or mutual fund while taking a tax loss when their values are down. This can be done by selling the investments and waiting 31 days before repurchasing them again.
An alternate strategy for those wanting to stay invested is to sell the stock or fund and immediately buy a similar stock or fund, e.g., sell Exxon and buy Chevron.
Capital gains are generally taxed at lower rates of 0 percent to the extent that the taxpayer is in the 10 percent and 15 percent brackets and for 15 percent for income falling into the higher brackets.
However, special rates apply to recapture of depreciation when selling business or rental assets and collectibles. You will want to discuss situations involving these with a tax professional.
Bad debt rules are often misunderstood. Business bad debts are reported on Schedule C and must arise from cash actually loaned out or amounts previously included in income. Nonpayment of expected income does not qualify.
Nonbusiness bad debts are reported as short-term capital losses and may be deducted only in the year that they become worthless. There are steps you must take to establish the worthlessness of the obligation and documentation that should be attached to your tax return.
An important tax benefit we can receive is that when appreciated assets are inherited, the cost basis is adjusted to the fair market value at the date of death.
If an asset has gone up in value this results in a step-up in cost basis. When one of two joint owners dies, his or her half of the asset receives a step-up in cost basis. Many married taxpayers hold title to assets as community property, since when one spouse passes on, the property receives a 100 percent step-up in cost basis.
Sometimes when a person has a terminal illness they will gift their residence or other property to relatives to simplify their affairs. To do so can create a large future income tax liability for the heirs, since the tax benefit of a step-up in cost basis will be lost. A living trust is one way title can be passed on without probate while still preserving the step-up in cost basis.
Installment sales allow the taxpayer to report the gain over several years, often resulting in less tax paid since a greater portion falls into the lower tax brackets. The gross profit percentage is calculated the initial year and applied to principal payments in subsequent years.
When depreciation is recaptured as ordinary income, it must be recognized in the year of sale, regardless of what, if any money is received. Special rules apply to sales involving related parties that can trigger early recognition of the total gain if the property is resold within two years.
Some taxpayers have incurred losses in their variable annuities after the financial crisis. If the annuity is surrendered, a loss is incurred.
However, this is not a capital loss since annuities are not capital assets. Reporting of the loss is currently an area open to interpretation. The IRS thinks the loss should be reported as a miscellaneous deduction on Schedule A for itemized deductions and subject to the 2 percent of adjusted gross income threshold.
There has been a tax court case where the loss on an annuity was determined to be an ordinary loss. Ordinary loss treatment is normally much more favorable to the taxpayer.