This year-end is proving to be one of the most difficult for investors in many years. There's the uncertainty resulting from the financial credit crisis and government reactions to the crisis. There's the uncertainty from the close presidential election. There is also the uncertainty from the existing tax laws, under which the tax rates for capital gains and dividends and the top marginal tax rates for ordinary income would increase in 2011 under current law even if nothing were done by Congress.Faced with this uncertainty, the market has been in retreat, evaporating gains and producing potential losses. While most investment advisors are advising clients to remain in the market, and even use downturns such as this as an opportunity for further investment, taxpayers facing investment losses should keep in mind some tried and true tax planning opportunities, as well as some potential new developments in the tax law.
Under standard, long-applied rules, short-term capital losses are offset against short-term capital gains and long-term losses are offset against long-term gains. Any net short-term losses are then offset against any net long-term gains and any net long-term losses are offset against any net short-term gains.
Any net capital losses then may be offset against up to $3,000 of ordinary income (or $1,500 for those married individuals filing separately), with the balance carried over to future years, retaining its character as either short- or long-term. From a tax point of view, therefore, having $3,000 of net capital losses creates the best possible tax result for the current year by offsetting ordinary income that otherwise could be taxed at up to 35 percent.
Taxpayers attracted to the idea of generating capital losses in order to offset ordinary income should be cautioned to observe the wash sale rules, also a long-standing part of the tax law. Selling a stock to generate a loss and repurchasing the same stock within 30 days on either side of the sale date will result in the loss not being recognized for tax purposes.
Taxpayers interested in generating losses while desiring to hold onto their present investments for long-term gain potential must therefore expose themselves to at least 30 days of reduced investment in the stock to preserve capital loss treatment. Some investors feel comfortable "getting around this rule" by repurchasing stock in a similar company with a similar balance sheet in the same industry.
THE CANDIDATES' TAKE
Under current law, existing capital gain, dividend and ordinary marginal tax rates will survive through 2010. The McCain campaign proposes preserving these tax rates beyond 2010. The Obama campaign proposes re-establishing the 36 percent and 39.6 percent marginal tax rates and raising the capital gain and dividend rate for those with incomes over $250,000 to 20 percent from 15 percent. If Obama is elected with a Democratic Congress, it's possible that he would push to enact his tax program in his first year in office, a successful strategy of several recent presidents.
Year-end tax planning, which generally would argue for postponing capital gains and accelerating capital losses, might be reversed this year, since capital gains realized this year would have a maximum tax rate of 15 percent. Historically, increases in capital gain rates have not been made retroactive, in order to give taxpayers time to realize gains at the lower rates, and therefore generate more government revenue. Retroactively applied rate increases would encourage taxpayers to continue to sit on their gains.
Still, if taxpayers are concerned about the potential for new tax rates to apply next year, year-end planning might include more of an emphasis on realizing any capital gains left in the portfolio before year's end. By the same token, capital losses might be better postponed to offset capital gain in future years that might be subject to a potentially higher tax, or to offset ordinary income up to $3,000 per year that might also be subject to a potentially higher marginal tax rate in future years.
THE BAILOUT PACKAGE
As this column is being written, Congress has just enacted a financial bailout package designed to help restore the credit markets and stem further deterioration in the economy. There are a number of non-tax provisions that might provide some comfort to investors.
At least two provisions in the tax section of the legislation would also address the treatment of certain losses.
One provision would extend the provision providing for an exclusion of mortgage debt forgiveness on a principal residence for an additional three years, through 2012, rather than expiring at the end of 2009. This appears to be a recognition that the housing crisis is likely to continue for a while, and homeowners facing foreclosure will not also face the additional burden of tax on the forgiveness of their mortgage debt.
Another provision in the legislation would permit banks and other financial institutions that had investments in preferred shares of Fannie Mae and Freddie Mac to treat any losses on those shares as ordinary losses, rather than capital losses. This would apply to preferred shares held on Sept. 6, 2008, or preferred shares sold or exchanged on or after Jan. 1, 2008, and before Sept. 7, 2008.
It appears that many banks around the country have invested heavily in Fannie and Freddie, and their financial security has been impaired by the federal takeover of those institutions.
A significant tax package was added to the final version of the bailout legislation that includes AMT relief, extension of expired tax provisions, energy tax incentives, disaster relief and a few revenue offsets. The disaster relief provisions include a suspension of the normal casualty loss limitations. One of the revenue raisers somewhat relevant to our discussion would require brokers to report the cost basis of stock transactions under circumstances where the basis would be known to the broker.
By the time that you read this column, Congress will have adjourned for the elections, which will be at hand. Although there will still be a chance for further year-end action by Congress in a lame duck session, year-end planning for investment losses will include the tax provisions in the financial bailout package passed by Congress and can shortly include the outcome of the election.
This information should help tax practitioners advise their clients as to whether to follow the normal year-end tax planning strategies for realization of losses, or whether the election and the passing of the financial bailout package has created some unique considerations for realization of losses for year-end 2008.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
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