To get this complicated tax concept to
work to your advantage, the first step is to understand how you are being
taxed. A variety of variables come into play when you are calculating
your tax rate:
3- The type of asset. (As government irony would have it, your trilobite collection would most likely be taxed at a higher rate than your mutual-fund shares.)
Once you’ve got a grasp on the different rates, you can strategize and use your losses to offset your gains.
“Almost everything you own and use for personal purposes, pleasure or investment is a capital asset,” notes Smartmoney.com’s Bill Bischoff. “The IRS says when you sell a capital asset, such as stocks, the difference between the amount you sell it for and your basis, which is usually what you paid for it, is a capital gain or a capital loss.”
Your cost basis is the difference between original purchase price (Adjusted for various things including additional improvements or investments, taxes paid on dividends, certain fees, and depreciation.), and the amount you sell the property for.
Now for the exemptions….
1. One person can exclude up to $250,000 in capital gains on the sale of real estate if the owner used it as primary residence for two of the five years before the date of sale. This deduction jumps to $500,000 for a married couple filing jointly. For more information check in with IRS Publication 523.
2. In one of those funny government twists, you must report all capital gains, but you may deduct capital losses only on investment properties. If you or your business realize both capital gains and capital losses in the same year, the losses can be claimed as a tax deduction against ordinary income and taxable capital gains. For individuals, if losses exceed up to $3,000 in a year, any additional net capital loss can be "carried over" into the next year and again "netted out" against gains for that year. Corporations are permitted to "carry back" capital losses from prior years to offset capital gains, thus earning a kind of retroactive refund of capital gains taxes. (See your accountant for details.)
If you have taxable capital gains, you may be required to make estimated tax payments. See IRS publication 505, “Tax Withholding and Estimated Tax,” for more information.
Capital gains and losses are reported on Schedule D tax form, “Capital Gains and Losses,” and then transferred to line 13 of Form 1040. There is a worksheet in the 2005 Instructions to Schedule D to figure a capital loss carryover to 2006.
If you’re looking, you’ll notice that toward the end of each calendar year, there is a tendency for many investors to sell their investments that have lost value. Note the increased number of investment properties on the market come September.
3. Individuals are able defer capital gains taxes with tax planning strategies such as a charitable trust, installment sale, private annuity trust, and a 1031 exchange.
The United States is unique in that its citizens are subject to U.S. tax on their worldwide income no matter where in the world they reside. U.S. citizens therefore find it difficult to take advantage of personal tax havens.
Additional information on capital gains and losses is available in IRS publications 550, “Investment Income and Expenses,” and 17, “Your Federal Income Tax.” You may download the publications or order free copies by calling 1-800-TAX-FORM (1-800-829-3676).
For more information on capital gains, try www.smartmoney.com.
YOU WILL ENJOY THE 1031 EXCHANGE
An Ocean Park senior citizen was startled when a real estate agent bought an unsolicited offer for the corner storefronts he’d owned for decades. Now he was torn. He didn’t really want to sell because he enjoyed the monthly income, but if he sold, it would free him from responsibility. But then, there was the issue of capital gains. He talked to his accountant about it. His accountant suggested a 1031 exchange.
"It used to be that on a scale of 1 to 10 in importance in estate plans, real estate was about a 5. Now it's at 8," notes attorney Yaron Hassid. "Real estate values have been going up so rapidly that it's now seen as a safe investment. Five years ago, the stock market was perceived to be safe with 10% returns."
If you own (or want to own) an investment property, a 1031 exchange can become the basis for increasing your real estate wealth by making periodic trades up for larger properties.
Suppose you purchased a triplex north of Wilshire during the real estate dip of in the early ‘90s.These days, the property is valued more than a million dollars, but thanks to rent control, you’re bringing in about $40,000 per year in revenues. As authorized by Internal Revenue Code 1031,you can exchange that property for something more desirable - say a three unit shopping center with a billboard bringing in $168,000 per year in revenues.
Internal Revenue Code 1031 has allowed tax-deferred exchanges of investment and business properties since 1921. To qualify for tax-deferral when selling a property, an individual is required to trade an income generating property used for investment or business for a “like kind” property (or properties) equal to or greater than the equity of the one they are selling.
A qualified tax-deferred trade up is viewed, tax wise, as one continuous investment. So, if you exchange your property, you avoid paying taxes.
There is no limit to the number of times or the frequency you can use IRC 1031 to escalate your real estate wealth without paying capital gains taxes. Buy a fixer on Tuesday; sell it Thursday, by a bigger fixer next Tuesday. As long as it’s an investment property and not a primary residence, you’re good to go.
Noted real estate columnist Bob Bruss sites at least 10 reasons for exchanging real estate
1. Pyramid your investment equity without tax erosion of your sale profit.
Commonly known as a Starker Exchange, Internal Revenue Code 1031(a)(3) allows an investor to sell their property, and have the sales proceeds held by a qualified third party, while they purchase their replacement property or properties. IRS time limits give the investor 45 days to choose their next properties, and 180 to complete their tax-deferred transaction.
“If you don't have everything lined up you can miss those deadlines," notes Margaret McDonnell, president of 1031 Corp. "It sounds like a long time, especially the fact that you have 180 days to close on a new place, but it's really very short.”
Another option is a reverse exchange. As of late 2000, IRS Revenue Procedure 2000-37 has allowed the replacement property to be acquired by the third-party accommodator and held until the old property is sold.
Death is the ultimate tax shelter. Any capital gain tax you would have owed if you sold your real property (and other assets) is forgiven upon your death, and your property heirs receive a new "stepped-up tax basis."
For details, please consult your accountant.