Advising clients on how to reduce taxes for this year and even gain a head start on tax planning for future years is a significant way to set you apart from competitors while sending a subliminal message that your fees are worthwhile. These tips also provide a perfect lead-in to the multitude of other planning issues clients ought to address to meet their expectations. For instance, when securities markets swoon and apprehensive investors bail out of their holdings, they console themselves with deductions for capital losses at Form 1040 time. But it's important to make clients aware that long-standing rules limit their write-offs for losses on sales or redemptions of shares of individual stocks, bonds, mutual fund shares and ETFs. The big hurdle is Internal Revenue Code Section 1211, which caps the deduction at $3,000 for both single filers and married couples filing joint returns--$1,500 each for married couples filing separate returns. These dollar limits have not been revised upward since they went on the books in 1978, when Jimmy Carter was in the White House.
In my experience, many individuals focus just on the $3,000 ceiling and forget that the tax code authorizes them to be resourceful when they incur capital losses. Section 1211 allows taxpayers to fully offset capital losses against capital gains on other investments. Investors also fail to take advantage of another significant break: They are entitled to use losses on sales or redemptions of stocks, bonds, mutual funds or ETFs to offset gains on sales of capital assets other than stocks, bonds, etc. (Of course, they cannot claim capital loss deductions on sales or redemptions of assets held in IRAs and other tax-deferred retirement accounts, where gains and losses are not currently taxed.) This opens many possibilities, for instance, profits on sales of collectibles, vacation homes, undeveloped land, active farms and rental and commercial property.
Take, for example, the case of Marilyn Paul, who plans to sell her personal residence and anticipates a capital gain greater than the exclusion amount of up to $250,000 for singles and married couples filing separate returns or $500,000 for joint filers. Marilyn should consider realizing losses on shares of stock or mutual funds to offset the taxable portion of her gain.
Buried in the tax code's fine print is a provision that bars offsets of capital losses against qualifying dividends--dividends taxed at a top rate of 15 percent...no matter that this rate is the same as that for capital gains.
Another constraint proscribes offsets of capital losses against income from conversions of money from traditional IRAs into Roth IRA accounts or income from required minimum distributions from IRAs, 401(k)s, Keogh plans and other retirement arrangements. It is neither here nor there that the accounts swelled only because the securities they held appreciated.
How much tax relief becomes available for 2008 when net capital losses exceed capital gains? Section 1211 blesses offsets of net losses against as much as $3,000 of ordinary income--a wide-ranging category that includes salaries, pensions, interest and "dividends" (considered interest) paid on savings accounts, certificates of deposit or similar savings vehicles, Roth conversions and required distributions from tax-deferred plans. If necessary, however, investors can carry forward unused losses over $3,000 into 2009 and succeeding years.
Joe and Barbara Fontana, for example, expect to have long-term losses of $60,000 and long-term gains of $40,000, resulting in a net long-term loss of $20,000 for 2008. On Form 1040's Schedule D, they subtract $3,000 of their loss from ordinary income, leaving them with a carryover of $17,000 from 2008 into 2009. On the Fontanas' 2009 Schedule D, they use the remaining loss (unless offset by capital gains) to trim ordinary income by up to $3,000, leaving them with a carryover of $14,000 from 2009 to 2010.
Another state of affairs--this one from the pages of my real- life client roster--includes a married couple we'll call Rudolph and Flavia Colman. Rudy is a 30-something investor with an unshakeable faith in the "market-timing fairy." Alas and unsurprisingly, Rudy relied on a seer who was no Nostradamus.
Flavia, a former Victoria's Secret model whom men find totally irresistible, sacrificed her career to become a trophy wife circa "Sex and the City," with pricey Manolo Blahnik stilettos for her toes and six-carat Harry Winstons for her fingers.
Just how maladroit was Rudy at anticipating market movements? In 2000, a few days before the prices of technology stocks crested, he moved money into mutual funds that invested in dot-com ventures--despite his mate's prescient advice to buy bond funds instead. Fortunately for Rudy, Flavia--nobody's stereotypical arm candy and who has forgotten more about tax planning than Rudy will ever know--persuaded him to place ownership of the fund shares in both their names.
The Colmans suffered losses of $90,000 when the dot-com bubble burst. In the event that the couple realizes no future capital gains and the cap stays set at $3,000, they will write off all of their losses only after the passage of 30--count 'em, 30--years, a number not necessarily daunting, as Rudy is hale and hardy.
But what if Rudy kicks off before they are able to deduct the entire $90,000? Problem for Flavia? Not at all, provided she lives long enough. After filing their last joint 1040 form, she just continues to claim unused losses in subsequent years on her own returns, whether filed singly or--should she remarry--jointly with her next husband.
Had Rudy been the sole owner at the time of his death, Flavia's carryover would have been derailed. This is so even when the couple's final return was a joint one, and for the two years after Rudy's death that surviving spouse Flavia qualifies for joint return rates because she has a dependent child.
Section 1211 imposes no time limit on using up carryover losses. All the same, the Colmans must use their carryovers as soon as possible. Like other investors, they cannot forego a carry-forward deduction in a lower-bracket year and save it for a higher-bracket year. Another stipulation prevents them from claiming losses on sales of assets held primarily for personal purposes, such as year-round homes, automobiles or furniture.
To compound the Colman's tax travails, some of their stocks or bonds became worthless, thanks, perhaps, to the increasing number of corporate bankruptcies. To nail down their loss deduction, they must be prepared to show that the shares of stock had some value at the close of 2007 and only became entirely worthless during 2008...no matter that the shares are no longer traded and are practically worthless. If the IRS audits their return and questions the loss, the burden is on them--not the Feds--to establish that there is no current liquidating value, as well as no potential value.
When are they entitled to "recognize"--that is, write off their loss? On the last day of the year in which the shares become worthless. To support their deduction, they should obtain a statement confirming worthlessness from a broker, the bankruptcy court or the company that issued the shares.
Julian Block, an attorney based in Larchmont, N.Y., conducts continuing education courses for financial planners and other professionals. Information about his books is at www.julianblocktaxexpert.com.