Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)

Part III. Investment Income and Deductions

Chapter 11. Taxable Investment Income

Know the Tax Rates, Strategies, and Traps of Each Investment Option before Going All In

There are many ways in which investments are taxed. It is important to understand how a particular investment will be taxed before jumping in because that taxation will have a real effect on the true earnings that you receive. This chapter focuses on the following areas of investment taxation:

·     Capital gains income

·     Dividend income

·     Interest income

·     Mutual funds—mutually confusing taxation

·     Limited partnerships

Capital Gains Income

When you purchase an investment or business asset, and then later sell it, you generally must report the gain or loss from that sale on your tax return. If you sold the item for more than you paid for it, you have a gain. If you sell it for less than you paid, you have a loss. The price that you paid for an asset is called your “cost basis” (plus connected expenses, like commissions, minus things that lower the basis, like depreciation). It is your cost basis, compared to the sale price, that determines whether the sale resulted in a gain or a loss.

Icon   Note   It is important to understand that you are taxed on a gain or loss only after it has actually been “realized.” That means that you have tax consequences only once a sale is complete. If you buy a share of stock for $100 that is now worth $300, you have a $200 gain in the value of that stock (sometimes referred to as a “paper” gain, because the value is only on paper—it has not been turned into cash in your hand). However, you will not be taxed on that gain (or loss, if that be the case) until you make it real—meaning the deal is done and the value (for you) will no longer fluctuate because you have sold it.

The tax code further distinguishes the sale of an asset as “short-term” or “long-term.” If you have owned the asset for one year or less when you sell it, you have a short-term sale. If you have owned it for a year and one day (or more), you have a long-term sale. Long-term and short-term sales are treated very differently in the tax code. Short-term sales are treated as ordinary income, whereas long-term sales receive special treatment through lower tax rates.

The government has a vested interest in seeing the economy grow. An essential part of economic growth is the willingness of individuals to risk their money (or capital) by investing in business. Because of the critical role that business investments play in the health of the nation’s economy, the tax code gives an added incentive to make those investments. If you do and you make money, you are taxed at a lower rate than you would be on other sources of income. This special treatment of investment income is known as “capital gains” income. However, onlylong-term gains get tax-favored treatment.

Icon   Note   Long-term capital gains have not always received special treatment in the tax code, and they may not in the future. There has been a lot of discussion in recent years about increasing the tax rates on gains for some, or all taxpayers. Some have even proposed taxing these gains at ordinary rates. Be aware of changes that are proposed and capture the low rates (by selling appreciated assets) before they go up, if that happens.

When considering selling any capital asset, from stocks to real estate, you should always be aware of how long you have held the asset. If the 12-month period is near, it may be worthwhile to hold the asset a little longer in order to significantly improve the tax consequences of the sale.

image   Example   Jenny’s broker called her one day to recommend selling a bond she owned. The value of the bond had risen significantly, and the broker thought it wise to capture the gain and reinvest the proceeds into another bond. Although this assessment may have been correct from an investment standpoint, the broker neglected to consider the amount of time she had held her bond. She sold the bond one week short of a year from her purchase date. Because of this, Jenny had to pay taxes equaling 33% of the gain, instead of the 15% she would have paid by selling it one week later. She likely would have made a similar gain from selling the bond a week later, but would have paid less than half of the tax.

Icon   Note   Remember that taxes are only one factor to consider in your decision to sell an investment. Other factors may outweigh the tax consequences.

Long-term capital gains tax rates are at historical lows. The rate is 0% for those who are in the 10% and 15% marginal income tax brackets! It is amazing that for many people this income is not taxed at all. Regardless of your tax bracket, there is a significant difference in tax rates for long-term capital gains income compared to ordinary income. See Table 11-1 for a summary of the current long-term capital gains tax rates, based on Adjusted Gross Income (AGI).

Table 11-1. Long-term Capital Gains Rates Based on AGI

Table

image   Tip   When you’re investing in a mutual fund, rather than direct ownership of bonds and stocks, one important factor to consider is the ratio of long-term to short-term turnover of the assets within the fund. Mutual fund managers can differ significantly in their tax sensitivity as they manage the fund. Their choices in that regard will pass directly to your taxes and could significantly affect the net-of-tax return you earn on your investment.

As you plan for capital-gains income as a tax reduction strategy, be aware of the effect of additional capital-gains income on your overall income taxes. Even though capital gains are taxed at a lower rate, they are still a part of your AGI calculation, which in turn affects your ability to claim certain credits and deductions. It is possible to capture capital gains, assuming they will be taxed at a lower rate, but end up paying more income taxes than you expected because the effect of the gains on your AGI kept you from claiming certain deductions and credits.

image   Example   Mark and Melinda would have normally had an AGI of $167,000, except they sold some investments anticipating lower capital gains tax rates on the sale. The $20,000 in gains from their investments pushed their AGI up to $187,000. Consequently, their allowable itemized deductions were reduced by $200. Fewer allowable deductions translates into more taxes paid on ordinary income, and in Mark and Melinda’s case, this meant that their marginal taxable income crossed into a higher tax bracket. In effect, the rate they paid by capturing capital gains income was actually higher than the long-term capital gains rate.

Although the example may not have translated to a much larger tax bill, it took into account only one affected deduction. If Mark and Melinda’s increased AGI had reduced or eliminated other tax deductions or credits, the results could have been much more dramatic.

Loss Sales and Wash Sales

Because long-term capital gains receive favorable treatment in the tax code, capital losses have special limitations. If you lose money on the sale of a capital asset (you sold it for less than your basis), that loss is allowed only to reduce other capital gains income. If all of your capital gains for the year equaled $10,000 and all of your capital losses equaled $25,000, you would have an overall net loss of $15,000 ($10,000 capital gains – $25,000 capital losses = $15,000 net losses). You are allowed to take those losses against the gains, reducing the gains to zero, but the use of the remaining $15,000 in losses is limited. You are allowed to take a maximum of $3,000 in capital losses against other income (reducing your overall AGI), but no more than that. Any net losses remaining would carry over to be used in future years—either reducing the gains from that future year or reducing other income by a maximum of $3,000.

image   Example   Last year Angel had a net capital loss of $8,000. He was able to use $3,000 of that loss to offset other income, but the remaining $5,000 was carried over to the current year. This year Angel had $6,000 in net capital gains. He was able to use the $5,000 loss carryover to offset those gains, so the net amount of gain that he will be taxed on this year is $1,000 ($6,000 current net capital gains – $5,000 loss carryover = $1,000 net taxable capital gains).

If Angel had had $10,000 in net capital losses in the current year (instead of the $6,000 gain), he would be able to use $3,000 of losses this year against other income and would then carry over $12,000 in capital losses to future years ($10,000 in current losses + $5,000 in loss carryovers = $15,000 in total capital losses. $15,000 in total losses – $3,000 currently used = $12,000 in loss carryovers to future years).

Sometimes investors use a strategy called “harvesting losses.” If an investor has 20 stock positions in his portfolio and has sold one that resulted in a gain, he may consider also selling another position for a loss in order to offset that gain and effectively pay no taxes.

image   Example   Ned sold 100 shares of IBM stock for a total gain of $600. Ned also owns 100 shares of Netflix stock, which currently are worth $600 less than he paid for them. If Ned is ready to sell the Netflix shares, he could do so and have a $600 loss on those shares that would offset the gains from the IBM stock. Doing this intentionally, to reduce taxes, is called harvesting losses.

Often, investors don’t want to sell a stock for a loss. They hope to hold on to the stock until the price comes back and surpasses the price that they bought it at. Many times they still believe the stock is a good investment for the long term, but is just going through a slump in value. Many investors have eliminated gains by selling losing stocks and then immediately buying them back. In doing so they would realize a loss (in order to offset other gains), but would not lose their current position in that stock. This was a great idea—that is until the IRS said “No!” These shenanigans were not looked upon favorably, and so came into existence a rule known as the “wash sale.” This rule states that anyone who sells a stock or option for a loss and buys that same asset within a 61-day period surrounding the date of sale is not allowed to use the loss for tax purposes. If the purchase of a substantially identical stock is made 30 days before or 30 days after the sale (or the same day—thus the 61 days) then the sale for a loss is a “wash,” meaning it is counter-balanced by the purchase.

image   Example   Marcus owned 100 shares of Exxon. He originally purchased them for $8,000 ($80 per share). When he heard about an explosion on one of their oil rigs he was certain the value of the shares would plummet, so he sold the shares as quickly as he could for $70 per share, for a loss of $1,000 (100 shares × $10 loss per share = $1,000 loss). Two weeks later it was clear that the explosion was not significant and Marcus repurchased 100 shares at $85 per share (for a total purchase of $8,500). Marcus will not be able to claim the initial $1,000 loss on his tax return this year because he repurchased the shares within the 61-day window governed by the wash-sale rules.

In a wash-sale situation, even though the tax laws do not allow the recognition of a loss, a real loss actually did occur. In the preceding example, Marcus really did lose $1,000 from his investment when he sold the shares. The tax code compensates for this real loss, only the recognition of it comes in a future time, rather than immediately. When a person has a disallowed loss, the amount of the loss is added to the basis of the newly purchased shares. In the future, when the shares are sold, there will be a lesser gain (or greater loss) recognized because of the additional basis.

image   Example   In the preceding example, Marcus’s second purchase of 100 shares of Exxon was for $85 per share, or $8,500. If there were no wash-sale rules his basis in the new shares would be $8,500 and if he later sold them for $100 per share, or $10,000, he would have a gain of $1,500 on those shares.

With the wash-sale rules, though, the previous loss is disallowed and is added to the basis of the new shares instead. In Marcus’s case the unallowed loss was $1,000, so the new shares have a basis of $9,500 instead ($8,500 purchase price + $1,000 unallowed loss = $9,500 basis). Because of the adjusted basis, when Marcus sells the new shares for $10,000 he realizes a gain of only $500 instead of $1,500 ($10,000 sale price - $9,500 adjusted basis = $500 recognized gain). The $1,000 difference between the $500 recognized (taxable) gain and the $1,500 true gain on the sale makes up for the $1,000 loss that was previously disallowed.

The wash-sale rule does not occur in reverse. If you sell a stock for a gain and then buy it back within the 61-day window, you still must recognize that gain. Not fair? No, it’s not, but it works well for the government, and they are the ones writing the rules.

There is a way to use this inequity to your advantage, though. If there is a reason that you expect your tax bracket to increase in the coming year (because you expect your income to increase, or you expect the tax laws to change and the rates to increase), then selling all of your appreciated stock positions for a gain and immediately repurchasing them could be very beneficial. For example, if you expect your overall income in the coming year will push you from the 0% tax on gains to the 15% tax, then selling your gains this year (and immediately repurchasing them, if you still want the stock) could save a significant amount of tax. If you have $5,000 in gains you would save $750 in taxes by realizing those gains this year instead of the next. (You may save even more than that, depending on where your total AGI is and whether the gains would eliminate some deductions or credits.)

Another situation in which recognizing gains could be beneficial is if you have a large amount of carried-over losses. Because the tax code does not allow you to claim more than $3,000 in net capital losses against ordinary income, many investors who have experienced large losses could have those losses carrying over to future years for a very long time. Those investors now have a great opportunity to capture those capital gains, tax free. You can take as many gains as you have in carryover losses without paying a penny in taxes (or even increasing your AGI). If you then repurchase those same stock positions you have effectively increased the basis in that stock so that your future gains (and taxes on those gains) are reduced.

One other reason that it may be advantageous to use up your carried-over losses is that the losses carry over only while you are alive. When you pass away the losses are lost forever. This is completely unfair because those losses were real but never recognized for taxes. However, whether it is fair or not, those are the rules. It would be a benefit to recognize gains to go against those losses while you can.

Long-Term vs. Short-Term Arbitrage

When calculating the tax on capital-gains income there is a set order that you must follow. First, every individual transaction (sale) is calculated on its own to determine whether it was a gain or a loss (as well as determining if it was long- or short-term). Next, all of the transactions are grouped into two categories, either long- or short-term. Then, all of the transactions in each category are added together to determine whether there was a net gain or loss for that category. Next you must net any short- or long-term loss carryovers from previous years with any net gains or losses for the current year in their respective categories.

The final step in the calculation is where it gets difficult, but it is also where there is an opening for strategic tax savings (tax arbitrage). Table 11-2 describes what happens next.

The opportunity for tax arbitrage is found in rows 9 and 10 of the table, where you have net long-term losses and net short-term gains. Generally long-term losses offset long-term gains (which gains are taxed at higher rates) and short-term losses offset short-term gains (which are taxed at a higher rate). However, when you have net long-term losses and short-term gains, you are able to offset high-tax gains with low-tax losses, creating a special tax savings in the process.

If you have long-term capital-loss carryovers it could be very advantageous to sell positions for short-term gains, because you can use those carryovers against the higher tax short-term gains.

Table 11-2. The Final Step in the Capital-Gains Tax Calculation

Table

Special Rules for Collectibles

There is a category of assets that does not follow the regular long-term capital gains tax rules. If you have held a collectible for more than one year and sell it for a gain, that gain is taxed at a flat rate of 28%. The following items fall into the category of collectibles:

·     Stamps

·     Coins

·     Precious metals*

·     Precious gems

·     Rare rugs

·     Antiques

·     Alcoholic beverages

·     Fine art

*Certain precious metal coins and bullion are considered regular investment assets and not collectibles.

In a strange twist of the norm, it would actually be beneficial for most taxpayers to sell a collectible for a short-term gain (held for one year or less) rather than long-term, since short-term gains are taxed at ordinary income tax rates. Those ordinary rates include the 15% and 25% brackets, which most taxpayers fall into, and would actually be lower than the 28% flat rate for long-term gains on collectibles.

An Opportunity to Double-Dip

Capital gains taxation includes one of my favorite opportunities for “double-dipping” in the tax code. That opportunity comes when you contribute appreciated assets, such as investments, to a recognized charitable organization. When you make a contribution of an appreciated asset, you can take a deduction in the same way you would if you had written a check to the organization at the asset’s current market value. The bonus for contributing an appreciated asset, though, is that you will not have to pay capital gains taxes on that asset. You get a deduction for the full market value without ever recognizing (and paying taxes on) the gain. That’s two benefits for the price of one—a very rare treat in the tax code.

image   Example   Nicole purchased 10 shares of stock in August of year 1 for $100 per share (for a total cost of $1,000). In September of year 2 she sold the stock at a price of $300 per share, or $3,000. This transaction resulted in a long-term gain of $2,000. Her tax bracket for long-term capital gains was 15%, so she had to pay $300 in tax on the gain.

In year 2 Nicole also donated $3,000 to the Red Cross, her favorite charity. She did so by writing a check. This donation gave her a $3,000 deduction, resulting in a tax savings of $840 (she’s in the 28% income tax bracket).

As an alternative, Nicole could have donated the $3,000 to the Red Cross in the form of her shares of Google stock, instead of selling the shares and writing a check to the Red Cross. If she had done so, she would not have had to pay the $300 capital gains tax and would still have received the $840 in tax savings from the deduction. This would have brought a combined $1,140 tax savings, or 38% of the value of the contribution.

This special tax treatment is available only for assets that have long-term gain. Donations of assets that have been held for a year or less (short-term gains), or of an asset that would bring ordinary income when sold (such as inventory) are not given this special tax treatment.

The total value (of deductions) that comes from donations of appreciated assets cannot exceed 30% of your AGI for the year. Any deductions of appreciated assets that are more than 30% of AGI can be carried forward for up to five years for future deductions. After five years the carry-forward disappears.

images   Tip   Do not use this strategy for assets that would sell at a loss. In that case it would be more beneficial to sell the position, capture the loss so that you can use it on your tax return, and then donate the cash to charity for the deduction. It is exactly opposite to the strategy for donating positions with capital gains.

The Effects of the Affordable Care Act (aka ObamaCare)

The key revenue-raiser in the Affordable Care Act (ACA) is the Medicare surtax (surtax is a tax levied on top of another tax). The surtax began in 2013. There are actually two surtaxes in the law. The first is an additional 0.9% tax on all wages and self-employment income (earned income) over a certain threshold. The second is a 3.8% tax on unearned (investment) income.

image   Example   Archie is a single, self-employed investment advisor. He spends a lot of his free time working on his personal investment portfolio. His total income for the year is $300,000, of which $250,000 came from his business and $50,000 from his investments. Because of the new law, Archie will pay a $450 surtax on his self-employment earnings and a $1,900 surtax on his “unearned” investment income (over and above the other taxes that he would normally pay on that income).

The 3.8% surtax of unearned income is somewhat alarming because it represents a significant shift in the tax rules. Before the ACA was enacted, Medicare taxes applied only to earned income. This change may signal a significant shift in the thinking of lawmakers: They are showing a willingness to apply employment taxes to income that does not come from employment in order to gather more revenue.

This new surtax will apply to nearly all unearned income, including interest, dividends, capital gains, rental income, royalties, and nonqualified annuities. It will not apply to income from retirement plan distributions—IRAs, 401(k)s, and so on—or to tax-exempt interest.

This tax will be levied only on taxpayers who have a Modified AGI (MAGI) greater than $200,000 for single individuals, or $250,000 for married individuals. It is important to note that the $200,000 and $250,000 thresholds are not indexed for inflation, so a greater percentage of people will be affected by the tax every year. The ACA surtax effectively increases the tax rates for long-term capital gains to as much as 18.8% for anyone in the 25%, 28%, 33%, or 35% tax brackets, and 43.4% for those who find themselves in the 39.6% bracket. The 3.8% surtax is applied to the smaller of:

·     Total investment income, or

·     The amount of MAGI that exceeds the threshold.

image   Example   Doug and Maxine have an AGI of $280,000 and an investment income of $35,000. The 3.8% surtax will be applied to $30,000 of their ordinary income ($280,000 AGI − $250,000 threshold = $30,000, which is smaller than the $35,000 of investment income).

image   Example   Scott, who is single, has an AGI of $230,000 and an investment income of $10,000. The surtax will apply to the $10,000 of investment income because it is a smaller number than the amount by which his total AGI exceeds the threshold for single taxpayers ($30,000).

Icon   Note   This surtax gives an additional advantage to investing in municipal bonds, because the interest from these bonds is not counted as investment income. Since the tax is on the lesser of MAGI or investment income, if all (or most) of your investment income comes from municipal bond interest there will be little or no surtax.

Icon   Note   There is a heavy marriage penalty in this surtax. Two unmarried individuals who live together could each earn $200,000 (for a combined income of $400,000) without paying the surtax, while a married couple can earn only $250,000 before paying it.

An Example of the Rigged Tax Code

Remember the discussion of unintended consequences in Chapter 5, showing that the way the tax code is written creates a compounding effect on the taxation of an individual as his or her income increases? The long-term capital gains tax is a prime example of this law in action.

Currently the tax rate on long-term capital gains is 0% for those in the 10% and 15% income tax brackets, and then it jumps to 15% for those in the 25% to 35% brackets, and then to 20% for those in the 39.6% bracket. This direct connection between the two tax brackets (capital gains brackets and income tax brackets) causes a “double whammy” effect on those individuals whose income increases to the point that they enter the 25% and 39.6% brackets. Each additional dollar of income is taxed at a rate of 25% (or 39.6%) and also causes a dollar of investment income to be taxed at 15% (or 20%) instead of 0% (or 15%). The true effective tax rate on that new dollar of income is 40% (25% income tax + 15% gains tax newly charged = 40%) or 44.6% (39.6% income tax + 5% additional gains tax charged = 44.6%).

Dividend Income

Generally dividends are regarded as ordinary, unearned income in the tax code. However, certain dividends are given a special “qualified” classification. This is significant because qualified dividends are taxed at the same rates as long-term capital gains. This special tax treatment is given to qualified dividends to encourage investment in the stock market, particularly investments in U.S. companies. The current rates for qualified dividends are listed in Table 11-3.

Table 11-3. Qualified Dividend Tax Rates Based on AGI

Table

For your dividend to “qualify” for this special treatment, you must hold the stock for at least 60 days in the 121-day window surrounding the date the dividend was declared (meaning, during the 60 days before, the day of, and the 60 days after the dividend declaration). The dividend must also come from a qualified business, which is either a U.S. business or a foreign business the IRS has given qualified status to. The brokerage firm you use to purchase investments can tell you which dividends qualify.

As it was with capital-gains strategy, there are several important factors to consider with qualified dividends. First, when investing in a mutual fund be sure to note the ratio of qualified to nonqualified dividends the fund manager is choosing. A high amount of nonqualified dividends will significantly change the amount of taxes that you are paying on that income. Second, dividends of any kind will increase your AGI, so the apparently low tax rates may not be so low effectively if they change your ability to claim deductions or credits (because of AGI-based phase-outs). This could also be the case if the dividend’s effect on your AGI causes other ordinary income to be taxed at a higher rate.

Finally, the surtax of the ACA applies to all dividends as well, potentially causing further erosion to the low tax rates offered on qualified dividends. For more details on any of these factors, read the details of the “Capital Gains Income” section earlier in this chapter.

Interest Income

In Chapter 10 I wrote about municipal bond interest, which is tax-free at the federal level, as well as at the state level if you live in the state of the bond’s issuer. In addition to state and municipal bonds, any interest earned from bonds issued by the federal government or its agencies is not taxable at the state level. In high-tax states that distinction could make a fairly big difference in the net-tax earnings of your investment. Beyond government-issued debt, all other sources of interest income are taxed at the federal level at ordinary income tax rates (such as interest from savings accounts, CDs, corporate bonds, etc.).

There are two unique features in the tax code in relation to interest income worth noting. These items can make it so the tax you pay from your interest-bearing investment is based not only on the actual interest you receive, but on additional factors as well. These additional items are:

·     Capital gains and bond swaps

·     Original Issue Discounts (OIDs) and zero coupon bonds

Capital Gains and Bond Swaps

As mentioned in the “Capital Gains Income” section earlier in this chapter, regardless of the taxable (or non-taxable) nature of a bond, when the bond is sold it is still subject to the rules governing capital gains or losses. If you buy a municipal bond for $980 and later sell it for $1,000 you have a taxable gain of $20, even though the interest earned while you held it is not taxable. This is an important factor to remember when implementing a strategy for tax-free income.

Armed with this knowledge, however, you can use the capital gains rules to your advantage in something called a bond swap. A bond swap occurs when you sell one bond and buy another in its place. The tax advantage is found when you sell a bond for a lower price than you paid for it, realizing a capital loss. That capital loss can then be used to offset other capital gains (or ordinary income, to a limited extent). Then a new bond is purchased in its place in order to maintain the interest income that was being produced by the previous bond.

You are probably thinking that this tactic would fall under the “wash sale” rules discussed previously. After all, those rules state that if you sell an asset for a loss and then buy a substantially similar asset within a 61-day period surrounding the date of sale, you are not allowed to use the loss for tax purposes. The key to avoiding the wash-sale rule when it comes to bonds is the phrase “substantially similar.”

The IRS considers a bond swap within the 61-day window to be a wash sale unless there are at least two features of the bond that are different. These features could include the issuer of the bond, the maturity date, the interest rate, or the rating. If at least two of these items are different then the wash sale rules will not apply.

image   Example   Stuart’s investment portfolio includes a Chicago, IL school district municipal bond. The bond pays 6% interest, matures in July of 2035, and has an AA credit rating. He paid $10,000 for the bond when he bought it and it has a current market value of $9,500. Stuart sold the bond, realizing a $500 capital loss.

The next day Stuart purchased a Milwaukee, WI school district municipal bond. The bond pays 6% interest, matures in July of 2035, and has an A– credit rating (a lesser rating, but it is insured) for $9,500.

Even though both bonds are municipal bonds issued by school districts, both mature in 2035, and both pay 6% interest, this will not be considered a wash sale because two features of the bond are different: the issuer and the credit rating. In this way Stuart maintains a very similar investment in his portfolio while at the same time capturing the capital loss that he can use against other income.

Original Issue Discounts (OIDs) and Zero- Coupon Bonds

When an entity issues a bond, it takes a significant amount of time and effort to go through the regulatory and marketing process of selling that bond to the public. It is impossible for the entity to know what the going rate of interest on the market will be for the bond’s issue date when the process is started months in advance. For this reason the entity will attempt to estimate what the rate will be and then let the buyers adjust between the market rate and the bond rate by purchasing the bond at a premium or at a discount.

image   Example   Widget Corporation needs to raise cash in order to produce its next great product. It decides to do so by offering bonds for sale on the market. Currently the market interest rate for corporations with their credit rating is around 9% per year. They move forward with their plans and print up bond certificates with a value of $10,000 each and an interest rate of 9%. Two months later, when they have received regulatory approval and marketed their bonds, the bonds actually go on sale. However, at the time they go on sale the going rate in the market has moved to 10%.

Who would pay $10,000 for a bond that earns 9%, when other bonds are available that pay 10%, all else being equal? The answer is that no one would. However, investors would be willing to pay $9,000 for that bond. Why? Because this discount makes the return of the two bonds equal. The Widget Corp. bond will pay 9% interest on the $10,000 face value, or $900 per year. However, if the investor only pays $9,000 for the bond and receives the $900 in interest, he is effectively receiving 10% in interest on his investment—the going rate on the market.

Widget Corporation is willing to sell the bond to him at a discount because it is the only way that they can sell the bond given the current conditions of the market. They will have to sell more bonds than they originally planned in order to raise the total sum of money that they needed for the new product’s production.

(It is actually a little more complicated than represented in this example, but for the purpose of presenting the key concept as simply as possible I have left a couple things out. The end result is essentially the same.)

This discount on the original face value of the bond is called an Original Issue Discount (OID). This is important because the tax code actually taxes the holder of the bond on this difference as if it were interest. If an investor purchases a $10,000 face value bond for $9,000 and holds the bond until maturity, the issuer will pay the investor $10,000 as a return of principal on the investment. The IRS looks at the extra $1,000 between the original purchase price and the final return of principal as essentially interest, because the difference in price was used to change the effective interest rate on the bond.

Because the OID is viewed as interest the IRS requires the bond owner to divide up that total “interest” as if he were receiving it over the life of the bond, for tax purposes.

image   Example   If the Widget bond in the previous example had a maturity of 10 years (meaning that 10 years after its issue the company would repay the initial face value to the investor and end the bond), then the OID of $1,000 would be divided up evenly over those 10 years and be recognized for tax purposes as $100 of interest each year ($1,000 OID ÷ 10 years = $100 per year).

The interesting part of this is that the “interest” that a bondholder is being taxed on for the OID each year is not actually flowing into the investor’s account. He never sees an inflow of cash, but is taxed as if he did. It is a kind of “phantom” income that is created by the tax code. Each bond that is sold at a discount is registered with the IRS, so your investment broker will know if the bond you are purchasing is subject to this OID recognition before you purchase it.

Zero-coupon bonds are bonds that actually take the OID concept to the extreme. These bonds actually pay no interest during the years that the investor holds them. They are sold at a steep discount, and the return on investment that the investor receives is from a much larger “return of principal” at the maturity of the bond. (Another way to describe it is that the bond issuer doesn’t pay anything until the maturity date, but at that date pays all of the principal and interest in one lump sum.) With this type of bond the investor will pay taxes on the “interest” evenly over the life of the bond, even though she does not receive that interest until the maturity date.

The opposite of buying a bond at a discount is buying it at a premium (paying more than the face value). This happens when the bond’s interest rate is higher than the current market rate—investors will pay more to get the higher interest rate. When this happens, a bond owner has two options in how to deal with the premium for tax purposes.

The first option is to declare a capital loss on the bond when it matures for the difference between what you paid for the bond and the principal that you receive from the issuer (if you paid $11,000 for a $10,000 bond face value, you could declare a capital loss for the $1,000 difference). If you held the bond for more than one year it would be a long-term loss, offsetting the lower-tax-rate long-term gains. In this way you would be taxed at higher rates for the interest and lower rates for the loss—not the best case scenario.

The second option is to deduct a portion of that premium evenly over the life of the bond. If you do this you must also amortize the premium paid on any other bonds in your portfolio, in the current year and in future years as well. You must also reduce the cost basis in the bond by the amount deducted each year.

images   Tip   You do not need to begin deducting the premium in the year that you buy the bond. You can begin deducting it in a later year but then must continue doing so in each year after that.

Mutual Funds: Mutually Confusing Taxation

Very often I have clients who come to me confused by the way they are taxed on their mutual fund investments. The confusion comes most often when the value of the investment went down during the year and yet the investor is taxed for capital gains. Not many things are more frustrating for a person than to lose money on his investment and then pay taxes on top of that.

With mutual funds, three major factors cause the confusion. The first comes from the fact that the mutual fund is really a lot of individual investments wrapped into one. When you think of your investment in the Ever Increase Fund, you think of it as one investment. In reality, that investment is really lots of little investments in dozens of individual stocks and/or bonds. Each one of those individual positions has its own purchase date and price, and eventually will have its own sale date and price. The purchases and sales of positions within the fund go on all of the time as the fund manager changes its investment choices, even when you have not added or withdrawn any money from the fund. As each position is sold, it is sold for a gain or a loss based on the initial purchase price. At the end of the year your portion of that sold-position’s gain or loss is passed on to you.

image   Example   The Ever Increase Fund (EIF) holds $100,000,000 of investments. Tina has invested $1,000,000 in EIF (representing 1% of the fund’s total investment) because she thinks it will bring her a great return. EIF’s managers have purchased a portfolio of stock positions of 50 companies, one of which is NewCastle Products, which makes beach toys. EIF’s total investment in NewCastle is $5,000,000 (which means Tina’s 1% share of that position is $50,000 of NewCastle stock).

When a new study comes out that people are having fewer children, NewCastle’s stock plummets because it is expected that the company will not be able to sell as many beach toys in the future. EIF’s position in the stock goes down to a market value of $3,000,000, at which point EIF sells its entire position in NewCastle for a $2,000,000 capital loss ($5,000,000 purchase price – $3,000,000 sale price = $2,000,000 loss). At the end of the year, Tina’s 1% portion of the capital loss ($20,000) will be passed on to her to report on her taxes (even though Tina did not sell her position in the fund—the loss is based on the individual position, not her overall investment in the fund).

When the gains and losses of individual positions that were sold during the year are passed on to the investor it can cause an interesting illusion. At the end of the year the investor sees the fund’s current market value on the year-end statement. In that person’s mind, whether she made money is based on whether the fund is worth more at the end of the year than it was at the beginning. In the mind of the IRS, whether an investor made money is based only on the individual investments that were sold during the year, not on the value of the investments held at year end. This can make it so that what the year-end statement shows and what is reported on the tax return can seem very contradictory.

image   Example   Despite the big capital loss that EIF experienced with the NewCastle stock, the fund as a whole actually did very well. In fact, all of the other 49 stocks in the fund increased in value. Cumulatively the fund doubled in value by year end. When Tina received her year-end statement it showed that her account value had doubled to $2,000,000. While she was thrilled with the results, she also cringed a little when she thought of the taxes she would have to pay on those gains. However, when she received the tax forms it showed that she had a $20,000 loss for the year. This is because EIF only sold one position during the year (NewCastle), so that is the only capital loss that is realized for tax purposes.

The second factor that makes mutual fund taxation tricky is that your position in the fund is a proportion of what the fund does as a whole, and not what you do with your shares of the fund. In addition, the fund must react to the orders of individual investors, which will, in turn, affect you. For example, imagine that the stock market begins to drop rapidly, so much that there is widespread investor panic. If individual investors begin withdrawing money from the fund, the fund managers must sell assets in order to raise the cash to send to the panicked investors. Even if you keep a cool head and decide to weather the storm, keeping your money invested, all of the gains or losses that the fund incurs because of the panicked investors will be passed on to you for your share of the fund. You did not sell anything, but because others did you will be taxed as if you did.

image   Example   A few years later the EIF fund has doubled in value again—reaching a total fund value of $400,000,000 and bringing Tina’s account value to $4,000,000. Then a major economic recession hits the world and the stock market begins to plummet. By year-end investors are in a panic and withdrawing money from the market indiscriminately, including withdrawing funds from EIF. The EIF fund is forced to sell many of its positions in order to deliver the money to investors who want out. At the end of the year the total value of EIF is half of what it was, and Tina’s account value is $2,000,000.

Tina is devastated to see her account value decimated, but then becomes irate when she receives tax forms showing capital gains of $300,000. How could she lose $2,000,000 from her account value and have $300,000 in capital gains?! Even though the market value of EIF plummeted, the positions that the fund sold were actually sold for a higher price than their original cost. As such, a gain on those positions is realized and passed on to Tina for tax purposes.

It is important to note that if none of the investors in the EIF fund had sold out, and if EIF managers had held their positions, there would be no tax implications of the market downturn. There are tax consequences only when positions are sold, and then those consequences pass on to every investor in the fund whether a particular investor sold shares or not.

The third factor affecting the taxation of mutual funds is the timing of when the funds pass gains (and other income) on to the investors. Funds are required to pass this income on to investors only at the end of the year. This accounting method could have a significant effect on an investor who buys into a fund at year end. The individual could end up paying taxes on gains that he never received.

image   Example   By December 15 the market crash has reached its bottom and Ned, a savvy investor, recognizes that it is about to go up. Ned feels that the EIF fund is a great investment and believes that it is an ideal time to buy into the fund before it starts to increase in value. He makes a $200,000 investment in the fund, representing 0.10% of the fund’s total value. When Ned receives his tax forms in the following year he will have a $30,000 capital gain to report (and taxes to pay on those gains). This is because the EIF fund issues the capital gain distribution on December 30t. Even though Ned didn’t own the shares when the gains occurred, he owned them when the gain was passed on and so he is taxed on a gain that he never saw.

It probably goes without saying, but make sure to know about potential income distributions in a fund before investing, especially when investing near the end of the year. It is a much wiser tax decision to wait until after those distributions are made before investing.

These three factors make mutual fund taxation fairly unique. Understanding how the income distributions of a fund work can help you make better decisions and help you avoid the frustrations that come from confusion. In addition, there are many funds that specifically tailor their decisions, as much as possible, to minimize the income that is passed through to their investors. All else being equal, it would be best to invest in one of these tax-minded funds.

Limited Partnerships and REITs

An alternative form of investment is found in owning shares of a Limited Partnership (LP) or of a Real-Estate Investment Trust (REIT). In essence, investing in an LP or REIT is the equivalent of buying part-ownership in a business, similar to buying stock in a corporation. There are, however, some key differences between the taxation of LPs and REITs versus the taxation of corporate stock.

One significant difference is that with an LP or REIT there is no “double-taxation.” With a corporation, the business pays tax on its profits and then the shareholder is taxed when the business distributes its profits in the form of dividends—resulting in a double-taxation of the same money. On the other hand, LPs and REITs are not taxed at the business level. Instead, all of the tax attributes (income, deductions, etc.) are passed on to the owners of the partnership and are taxed only once, at the level of the individual.

Because the tax attributes of an LP or REIT are passed through to the individual owners of the business, it makes the taxation of the “income” unique. Some of that income could come in the form of capital gains, some could be ordinary income, and some could be non-taxable return of capital. What usually occurs is that the overall tax rate of the income is reduced, at least in the short term.

image   Example   Jason invested $10,000 in an LP, which pays him an 8% distribution each year, or $800. Of that $800, $300 is taxed as ordinary income, $100 is taxed as capital gains, and $400 is not taxed because it is a return-of-capital.

The reason for this division of taxation is that the money came from different sources. The $300 represents Jason’s share of the business’s actual net income. Because it is from business income, it is taxed at ordinary rates. The $100 is Jason’s share of a capital gain that the business received from selling a large piece of equipment for more than its basis, or for a profit. Jason will pay tax at capital gains rates for that part of the income, because that is where the money came from. Finally, the $400 represents money that the business distributed to Jason (and other owners) that was over and above the profits that it earned that year. Since this portion was not from profit, it is seen as a return of a portion of the original amount of money that he contributed to the business ($10,000). With that return of capital, Jason’s basis in the investment will be reduced $400, becoming a basis of $9,600 in the LP investment.

The reduction in basis that comes from a return of capital will eventually lead to greater capital gains (or fewer losses) when the investor sells the shares in the business, or when the business closes. This form of investment usually results in fewer taxes per year on the distributions received (than what you might pay on other income sources), but eventually could result in a larger tax bill in the year the shares are sold.