Scarred by stocks and drubbed by real estate, several clients of tax attorney Richard Walton have realized tax losses in the high six- to low eight-figure range this year. "Some are even higher," says Walton, of counsel in the Los Angeles office of Buchalter Nemer. "That's not unusual for this type of economy."
Frankly, even a well-diversified portfolio is likely to sustain some noticeable losses in times of global economic softness, adds planner Ben Jacoby. "Any investor who doesn't accept this needs more education on how financial markets work," says Jacoby, senior financial advisor at Brinton Eaton Wealth Advisors in Madison, N.J.
But a client who has suffered a particularly bad flogging may be able to benefit from more than just education. Some thoughtful tax planning could assuage the client's hurt a little, too.
First, make sure the losses are really of capital. Sometimes the accountant will cast a loss as capital when, upon closer inspection, its true nature is an ordinary loss, says Walton.
In one case, he concluded that real property owned by a limited liability company was inventory held by a dealer. "The fact that the LLC had contacted another company about subdividing the land, even though nothing ever came of it, was the critical lynchpin that allowed us to argue the loss was ordinary, rather than capital. We've had other clients who were doing sufficient stock trades to qualify as securities dealers, and that made their trading losses ordinary," Walton says.
When the losses are in fact capital, it's important to remember that the Internal Revenue Code limits net capital loss deductions so that they can only reduce ordinary income by a stingy $3,000 annually.
To illustrate, consider someone who has realized $100,000 of long-term capital losses this year and $25,000 in short-term gains. He would use $25,000 of the losses to negate the gains. Then he deducts $3,000 of the remaining losses against 2008 ordinary income. That leaves $72,000 of losses-$100,000 realized, minus $28,000 utilized in 2008-and they are available to offset gains in future years and ordinary income up to $3,000 annually.
The problem is, when the taxpayer's losses are extremely large to begin with, it could take a long time to reap all of the tax benefits, and time is money. What's more, any losses that remain after a deceased client's final income tax return has been filed are forfeited. They cannot be deducted on the estate tax return, notes Walton, who has seen capital-loss carryforwards expire with clients. This is a genuine concern when advising the frail or very elderly. The tax tail should never wag the investment dog, of course, but having large losses on the books does present some interesting opportunities for advisors to consider.
Taking advantage of losses sooner rather than later requires realizing capital gains to report on the Internal Revenue Service's Schedule D. Suppose the client's portfolio isn't well balanced, for whatever reason. "This is the perfect time to get it properly allocated, because you can take gains and reposition the money how you want without triggering taxes," says Daniel P. Crimmins, managing member and founder of DPC Wealth Management in Ramsey, N.J.
Maybe the client has a low-basis, concentrated position he knows he should diversify out of, but he can't bear to fork over the tax on the gain. When large losses exist elsewhere in the portfolio, getting the client to divest is easier, Crimmins says. He persuaded one gentleman to realize a $200,000 gain in a single stock because of a $125,000 loss on another position.
Other possibilities include selling a business interest or liquidating a company. Walton reminds us that such actions ought to be driven in the first place by factors other than the tax consequence. "But if it's a good business decision, it's also a good tax decision when losses are available to offset the gain," Walton says. Look at all of the client's assets for opportunities to add value.
Beating The Kiddie Tax
The tax on investment income of children under a certain age, which is how the IRS terms what the rest of us call the kiddie tax, has a wider, more complex snare for 2008. Investment income in excess of $1,800 is taxed at the parent's rate for three categories of progeny: children under 18, 18-year-olds whose earned income is less than half their support and full-time students 19 through 23 whose earned income is less than half their support.
While it's harder to sidestep the tax now, some kids can do it. One is the student who keeps going and going (hopefully to graduate or professional school). Once age 24 is achieved, the student's investment income is taxed as her own.
Another candidate is the student on scholarship, says Mark Luscombe, principal federal tax analyst at CCH, the business information provider outside of Chicago (a WoltersKluwer company). Awards reduce the cost of this student's support, so she needs fewer dollars of earned income to satisfy the 50%-of-support test, Luscombe reasons.
Then there's the recent college graduate who is 23 or younger. To avoid kiddie tax, she'll need to earn more than half her support if she was a full-time student for five months in the year. She might well be able to earn more than half if she secures some type of work, and here's where having an entrepreneur Mom or Dad really helps. Your client can hire the daughter. The wages have to be appropriate for the work performed. But she doesn't actually have to use the earnings for her support to legally avoid the kiddie tax.
Mama, Don't Sell The House Just Yet
Recent widows and widowers may benefit from another change: Survivors now have two years from the date their spouse died to sell a personal residence the couple had jointly owned and exclude $500,000 of profit from taxable income, effective for sales in 2008 or later. Under prior law, the home had to be sold in the year the decedent passed; after that, an unmarried survivor was limited to excluding $250,000.
Walton is already helping one widow work the new rule. This couple had most of their wealth tied up in the ranch they lived on. "The rule change gives breathing room to survivors who need the equity in their homes to support themselves and whose wealth would be dangerously depleted if they were to sell in the current market," Walton says. To rely on the new provision, the couple must have met the usual requirements for taking the exclusion immediately prior to the first spouse's death. Additionally, the survivor must not be remarried.
Further note that it doesn't matter if the spouse died before 2008: It is only the sale that has to occur in '08 (or beyond), not the first death. So a survivor whose spouse died in '07 has until the anniversary of the death in '09 to sell and still get the $500,000 exclusion.
The change has no impact on the step-up in basis of a jointly owned residence at the first spouse's death. For that reason, some observers believe the new provision does little for taxpayers in community property states, since the basis of both halves of the home increases to market value at the first death, thereby removing from taxation all the gain to that point anyway.
An Election Play, And Other Tips
A traditional year-end strategy involves deferring income to the following year to delay taxation. However, Democratic presidential candidate Barack Obama has proposed replacing the current top marginal bracket of 35% with two higher brackets: 36% and 39.6%, reports CCH's Luscombe. "If Obama wins and you're in those potential new brackets, that might be incentive to accelerate income instead, and defer deductions. We have had a history of new presidents coming in and getting their tax agenda enacted in the first year," Luscombe says, citing George W. Bush, Bill Clinton and Ronald Reagan.
As of Labor Day, Congress had not extended several tax breaks that expired last year, the most high-profile of which is a higher exemption from the alternative minimum tax that keeps millions from alt min's clutches. One tax break that's important for beneficent clients is the ability to make qualified charitable distributions, which were available for '06 and '07.
QCDs let clients over age 70 and a half give up to $100,000 to charity directly from an individual retirement account without having to declare the withdrawal from the IRA as income.