Whole Ball of Tax 2003

TAX LAWS LET YOU TURN STOCK MARKET LEMONS INTO LEMONADE

(RIVERWOODS, ILL., January 2003) – Some investors who were battered in last year’s largely bearish stock market will be able to ease their pain a bit when they fill out their 2002 tax forms, according to CCH INCORPORATED (CCH), a leading provider of tax information and software. But, it takes careful record keeping and shrewd moves to make the most of the tax code’s provisions for stocks and other investments that go sour.

"If your investments lose value, the tax laws won’t restore your fortunes, but they can lessen the pain of your losses," said Mark Luscombe, JD, CPA, principal federal tax analyst for CCH. "There are ways for investors to use losing stocks to offset gainers and even shelter ordinary income from taxes. But, you have to know the rules, know the tax status of your investments and be willing to sell."

Being willing to sell both winning and losing investments is central to tax planning, because the tax laws generally recognize only "realized" gains and losses – stocks, bonds and mutual fund shares that are actually sold for a profit or a loss during a tax year. Gains and losses that exist only on paper don’t count.

"Many people are reluctant to admit they made a mistake, and so they hold on to a losing stock in hopes that it will rise again," Luscombe noted. "They also may be reluctant to sell a winning stock, even if selling a little earlier rather than later means they can minimize taxes on their gains. They often have to choose between actions that produce tax advantages and those that maximize investment gains."

In looking for possible tax breaks, investors first have to sort out winners and losers and also identify which investments can qualify for short-term and long-term treatment.

Investments held for 12 months or less are considered short-term; those held for more than 12 months are long-term. In figuring taxes, any short-term gains first are matched with any short-term losses and long-term gains with long-term losses. Then, net short-term gain or loss is weighed against net long-term gain or loss.

A short-term gain is taxed as ordinary income. For taxpayers in the 27-percent and higher brackets, long-term gains are generally taxed at 20 percent; for those in the 15-percent or 10-percent brackets, long-term gains on assets held for five years or less are taxed at 10 percent, gains on assets held for more than five years are taxed at 8 percent.

Taxpayers in brackets above 15 percent can qualify for 18-percent rather than 20-percent taxation of their long-term capital gains if they acquire the asset after January 1, 2001, and hold on to it for more than five years or if they made a special declaration on their 2001 return and hold on to an asset acquired before January 1, 2001, until at least January 2, 2006.

If you’ve bought various amounts of shares of a given stock at various prices over a period of time, you may have potential long-range and short-range gains, of varying amounts, depending on which lots of shares are sold.

You can specify which shares you want your broker to sell so as to reach the maximum tax advantage. If you don’t identify the specific shares to sell, though, you must use a "First-In-First-Out," or FIFO rule. Suppose you buy 100 shares in a company when they were low priced and another 100 after the share price rises dramatically. At a later time, the stock price declines to a bit above its original level. If you tell your broker to sell 100 of your shares but don’t specify which, you will show a capital gain; if you designate the high-priced shares as the ones to be sold, you’ll show a loss.

For mutual funds, investors can choose two additional rules for figuring their gains or losses. Both use the average cost of the shares in a fund. One method uses a single average price for all the shares, the other divides the shares into short-term and long-term holdings and calculates an average price for each group.

"Different methods produce different results," Luscombe observed, "but you have to make sure that your broker or mutual fund company can accommodate the method you choose. Also, once you use one of the averaging methods for mutual fund shares, you can’t switch to the FIFO or specific-shares method for the same fund without IRS permission."

If you have nothing but capital losses, you can use them to offset up to $3,000 in ordinary income – $1,500 in ordinary income if you are married but filing a separate return. Losses in excess of those amounts can be "carried over" to offset capital gains in future tax years.

"The $3,000 amount hasn’t changed for decades," Luscombe observed. "It’s one of the relatively few parts of the tax code that isn’t indexed for inflation. Bills to increase the allowable amount have been introduced, but thus far none has come close to passage."

If you have realized losses and paper short-term gains, you should consider two possibilities. One is to realize gains to the extent that they can be offset by losses. The other is to hold on to the short-term assets until they qualify for long-term treatment. The losses then are used to reduce income taxed at ordinary rates up to the $3,000 limit.

"Your first concern should be to use losses to offset gains that will be taxed at a high rate," Luscombe noted.

If you’re one of the fortunate few with realized gains and paper losses, consider selling losers to offset $3,000 in earned income as well as your gains.

In devising a strategy, also consider your current and future tax bracket.

"If you’re likely to move into or out of the 15-percent bracket, you’ll want to consider timing gains to take advantage of the lowest possible rates," Luscombe said.

There’s a special wrinkle in the tax law that affects investors with depressed portfolios. Suppose you currently have a paper loss in the stock of XYZ Inc., but you think it will rebound.

Your paper loss in XYZ does you no good. But can you sell shares now, to realize the loss, and buy the shares back again, so that you’ll profit if XYZ rises in the future?

You can – almost – but you have to contend with what’s known as the "wash sale" rule. This rule prevents you from realizing a capital loss if you engage in buy and sell transactions of "substantially identical" assets within 30 days of each other.

But you can buy another lot of XYZ today, wait 31 days and sell your original XYZ shares. This technique is called "doubling down." It gives you the opportunity to realize all of XYZ’s gains at a later date, but it makes the size of your loss in the stock uncertain until you actually sell. The other alternative is to sell your shares today and wait 31 days to buy a new lot at, what you hope, is still a reasonable price.

Salvaging a Deduction From a Sour IRA

A sour market ravages tax-advantaged retirement accounts as well as investments held for shorter-term needs. Unfortunately, if your 401(k) or deductible IRA shows a loss, there’s little you can do except hope for better days ahead. Any withdrawals from those accounts are taxed as ordinary income, even if the account has lost value. But if you have a Roth IRA (or a traditional, but non-deductible IRA) in which you’re showing a loss – that is, its value is less than your basis in the account – you can close it out and you might be able to get some relief in the form of a deduction. But, there are several catches to this strategy.

First of all, you have to close all your Roth IRAs to qualify for a deduction with respect to a Roth IRA. Similarly, you have to close all your traditional IRA accounts to qualify for a loss with respect to a traditional non-deductible IRA. You can’t shove all your losing investments into one Roth IRA and close it while keeping other Roth IRAs open. Second, you have to be able to itemize to take advantage of the deduction. Third, your losses must be greater than 2 percent of your adjusted gross income to be of any use, since they are taken as a "miscellaneous" itemized deduction, subject to a 2-percent floor. Finally, this type of deduction may expose you to the alternative minimum tax, or AMT. If you do, in fact, become subject to the AMT, the value of the deduction is lost.

"All in all, those are a lot of hoops to jump through to get a deduction," Luscombe notes. "You are also faced with the fact that a Roth IRA is presumably money you’ve set aside for some future purpose. Once the account is closed and the balance is distributed, is a similar sum going to be set aside?"

About CCH INCORPORATED

CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served four generations of business professionals and their clients. The company produces more than 700 electronic and print products for the tax, legal, securities, insurance, human resources, health care and small business markets. CCH is a wholly owned subsidiary of Wolters Kluwer North America. The CCH web site can be accessed at cch.com. The CCH tax and accounting destination site can be accessed at tax.cchgroup.com.

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