Here are some stories to carry you through the tax filing home stretch. (Illustration: Daniel Zalkus)

Come April, if not earlier, taxes occupy a huge space in your clients’ brains. If you’re providing tax advice, taxes are taking up valuable real estate in your brain, too, if they haven’t taken over entirely.

To help mitigate that brain drain, all last month, ThinkAdvisor.com published articles to help advisors sort through some of the issues their clients were facing while preparing their taxes, from how to manage taxes when they move to another state to calls to dump the tax code altogether.

Here are some of our favorite tax stories we ran in March.

Politics: These 6 Tax Avoidance Strategies Show Tax Code Is Unfair: Senator

“If our tax reform efforts are going to be successful, it is essential that the final—hopefully bipartisan—product is viewed as fair,” said Senate Finance Committee Chairman Orrin Hatch, R-Utah, at a hearing in early March. “If the American people do not believe a tax reform proposal is fair, it’s hard to see, politically, how it could be enacted.”

Hatch stressed that the last successful comprehensive tax reform effort took place during the Reagan era—nearly three decades ago.

“During that effort, President Reagan emphasized three principles for tax reform: efficiency, fairness and simplicity,” he said. “I’ve made no secret that I believe these same principles—along with a handful of others—should guide our current reform efforts.”

In late February, the Finance Committee had a hearing on efficiency and growth, and Hatch said a hearing on simplicity will be coming in the future.

Senate Finance Committee Ranking Member Ron Wyden, D-Ore., also pointed to President Reagan as a shining example for tax reform.

“[L]et’s try to meet the standard of fairness President Reagan set,” Wyden said in his prepared statement. “I want to hone in on two important things the ’86 act did, both of which should happen again. First, it gave fair treatment to wage earners, instead of punishing them by taxing their income at higher rates than others. And second, it cracked down on tax cheats who pry open loopholes and skirt their responsibilities.”

In conjunction with the February hearing, Wyden released a report that listed a number of strategies used by sophisticated taxpayers to substantially lower their tax burden.

“Sophisticated taxpayers are able to hire lawyers and accountants to take advantage of these dodges, but hearing about these loopholes must make middle-class taxpayers want to pull their hair out,” Wyden said.

Wyden’s report, “How Tax Pros Make the Code Less Fair and Efficient: Several New Strategies and Solutions,” highlights six major avoidance strategies used by many taxpayers to cut the taxes they owe dramatically.

The six tax avoidance strategies were identified for the report by the nonpartisan staff of the Joint Committee on Taxation and outside independent experts, relying on memoranda, examples and descriptions.

1. Using collars to avoid paying capital gains taxes. “Taxpayers who own appreciated stocks may lock in the gain by using a ‘collar’ that involves purchasing simultaneous options to buy and sell the stock at set prices to hedge against any stock price fluctuation,” according to Wyden’s report.

In this way, taxpayers are able to lock in a capital gain while bearing little economic risk for a change in value in the security and without constructively selling it. If there is no constructive sale, then no capital gains taxes are owed.

2. Using wash sales to time the recognition of capital income. Under the current treatment of capital gains, such gains are only taxed when realized.

Here’s how some taxpayers get around that: According to the report, they can “defer realizing capital gains but can realize capital losses at will without changing their economic position, by terminating a security that has lost money at the end of the tax year and then immediately repurchasing a substantially similar security. “

Selling the first security triggers the realization of the loss, while purchasing the second security does not undo this loss realization.

“In this way, some taxpayers can selectively recognize losses to offset capital gains income that would otherwise be taxed and then perpetuate the same loss position to offset gains at another time—thus, they effectively pay no taxes on the capital gains they do realize,” the report states.

3. Using derivatives to convert ordinary income to capital gains or convert capital losses to ordinary losses. While taxpayers trigger capital gains taxes through the sale or exchange of capital assets—if contracts on capital assets are held to maturity—the income flowing from the contracts will usually be taxed at ordinary rates even if the character of the income is capital.

4. Using derivatives to avoid constructive ownership rules for partnership interests. The report states, “In the 1990s, some taxpayers purchased swaps (or other derivative instruments) mimicking ownership of an investment partnership rather than directly purchasing an interest in said partnership. Taxpayers used such tax games to report long-term capital gains (taxed at 23.8% today), rather than the ordinary income and short-term capital gains (taxed at 43.4% today) that would have resulted from ownership of the actual partnership interest.”

5. Using basket options to convert short-term gains into long-term gains. A number of hedge funds have converted short-term capital gains to long-term capital gains by using a strategy colloquially called “basket options.”

Basket option transactions occur between hedge funds and banks. A bank first establishes an account, which is used to maintain a portfolio of securities (or a “basket” of securities). The bank then enters into a “basket option contract” with a hedge fund, which then, as the option holder, can exercise the option and receive a payoff equal to the profits generated by the basket of securities.

Though the account and the securities within it are technically owned by the bank, the hedge fund acts as an investment advisor and manages the assets within the account.

Profits remain in the account until the option is exercised, and when the hedge fund exercises the option it collects the profits associated with the account.

“The bank profits by collecting fees from the hedge fund. By characterizing the transaction as a derivative, a hedge fund is able to defer gains and losses from high-frequency trading and recast short-term capital gains as long-term capital gains,” the report states.

6. Avoiding income taxes by deferring compensation. Other tax avoidance strategies, the report says, can be used to delay paying taxes for years.

“Generally, this benefit allows executives and management employees to delay recognizing income to a future year, allowing investment returns on that deferred income to compound tax free until the income is finally paid out,” according to the report. —Emily Zulz

Real Estate: The Beach Condo Rental Tax Write-Off?

With the winter storms this year hitting the northeast and providing more than a little snow to the southern states (where any snow is considered a winter storm), many clients are already looking forward to some beach time this summer. I have clients ask me all the time about buying a beach house or condo with the intent of having a summer vacation spot, as well as a beneficial tax expense—assuming it’s a rental property for part of the year. However, just because the condo tax break option makes sense in theory, that doesn’t mean it will work out, especially for high-income clients.

So let’s discuss the mostly unknown hook, line and sinker of the IRS law on the personal beach condo purchase/rental property tax write-off.

Rental property (aka, beach condo) is primarily identified in one of two ways:

1. Property rented less than 15 days a year and used personally as a vacation home: This type of property is considered a non-rental property, therefore nothing should be filed on Schedule E of the 1040 relative to rental income or expenses. Fortunately, according to IRS publication 527, any income and expenses received from a vacation home or rental property with less than 15 days of rent are excluded from tax reporting (both income and expenses). While this may be beneficial from an income exclusion standpoint, most beach condo purchasers are usually geared toward personal tax write-offs rather than the rental income production, leaving this option very limited as a true tax benefit against a client’s current income earnings.

This option doesn’t prevent the client from deducting mortgage interest, property taxes or a casualty loss on the common Schedule A. However, all these write-offs are subject to the limitations of Schedule A or the specific line item limitations within the schedule’s deductions. Therefore, before the expense of new carpet, new appliances, remodeling, grass cutting, maintenance, insurance, utilities or anything else is spent, it might be a good idea to explain to your client that none of those expenses will provide a tax write-off benefit with this option.

2. Property rented more than 15 days and used personally as a vacation home: This type of property is deemed both rental and personal, therefore requiring expenses to be divided between rental use and personal use. For specific details on dividing expenses, see IRS Publication 527, but in simplistic terms, the division of expenses is done pro rata to the number of days rented versus not rented (key to note here is days rented versus not rented, as that is a big difference from personal days used versus the rest of the year).

Here’s where the gray area comes into play: Whether you had a net profit from rental activities or a net loss determines to what extent you can actually deduct all expenses or not. If you had a net profit (including all rental expenses and depreciation), you’re allowed to deduct all of your rental expenses. If you had a net loss from rental activities, this is where your rental expenses are limited (usually up to rental income), with all excess expenses allowed to carry over to future years.

While each of these examples seem somewhat straightforward and simple, now comes the hard lesson that most high-income earners learn on the back end of the beach condo purchase rather than the front end.

Exception for Rental Real Estate With Active Participation

First we have to define “active participation,” which involves the taxpayer owning at least 10% of the rented dwelling and participating in management decisions, even if outsourcing the rental services to another business. When the beach condo no longer becomes primarily a personal use dwelling and active participation is involved, the exception of passive loss write-offs becomes a reality, at least for some people.

The exception allows for up to $25,000 in rental activity losses to be written off against non-passive income (which is any earned income wages, retirement income, investment income, etc.). The hook, line and sinker is when the loss write-off exception becomes limited or excluded altogether, based on a client’s modified adjusted gross income (MAGI). See IRS Publication 527 for details, but for simplicity’s sake, we’re going to assume MAGI = AGI. Therefore, if a client’s MAGI is in excess of $100,000, the losses or expenses written off are limited to 50% of the difference between MAGI and $150,000. However, once the MAGI of the client reaches $150,000, the exception for loss write-offs has been completely eliminated and forced to carry over as future losses, which can only be used to offset future rental income. Hook, line and sinker!

So the point is to be very careful in advising your high-net-worth or high-income clients when they want to buy that beach condo or any rental property with the expectation of renting it and writing off all those first- or second-year improvements and expenses. They’ll be extremely disappointed at tax filing time if they can’t benefit from their cash outflow expense. —Andrew Rice

Investing: Tax Loss Harvesting: Beware of Unrealistic Expectations

Tax loss harvesting used to be an end of year tradition, with advisors and individuals poring over account statements to identify stocks that could be sold at a loss in December to reduce taxes paid the following April.

The intersection of academic research and technology has turned tax loss harvesting into a year-round activity for some clients, popularized first for larger investors by a few innovative asset managers and private banks, and more recently for the mass market by online advice providers.

Tax Loss Harvesting

Tax loss harvesting strategies are most effective when funded with cash, though in many cases we see strategies funded with the combination of cash and a legacy stock portfolio. Clients often turn to tax loss harvesting strategies after an active relationship has “gone wrong,” seeking a lower-cost and more tax-sensitive alternative to active management.

The most common approach to harvesting involves equities (though it can also be used with less effectiveness for portfolios of ETFs or mutual funds), with the portfolio manager building a portfolio that attempts to track an index before taxes while generating enough tax losses to beat the portfolio after tax.

The strategy takes advantage of the natural movement of stock prices, identifying losses among portfolio holdings and selling those positions to capture the loss. As stocks are sold, replacement securities are purchased so as to maintain the portfolio’s risk positioning relative to the benchmark.

For example, it’s common to replace similar securities for one another, such as Coke for Pepsi, Exxon for Chevron or Bank of America for Wells Fargo. Risk models help to identify less obvious substitutions, but these intuitive examples provide a good example of the risk management approach inherent in the strategy. Realized losses generated by the strategy are intended to be used to offset gains, thereby reducing or deferring tax pain.

Concentrated Stock Positions

An increasing number of investors hold a significant portion of their net worth in company stock and options. Although they are passionate believers in their company, many are all too aware of the risk associated with concentrating their net worth in a single company. Memories of the demise of companies such as Enron, AIG and Bear Stearns are all too fresh, and clients realize that events beyond their control could cause them to lose their nest egg and career at the same time.

One common method used to “unlock” concentrated potions is a tax loss harvesting portfolio. Tax loss harvesting is a way to reduce the tax impact of selling a portion of the concentrated holding and facilitates the creation of a more diversified portfolio.

Assumptions

There are a few key assumptions that inform our thinking about tax loss harvesting and have meaningful implications for the success of the strategy.

  • Portfolio tax status: Harvesting strategies only work in taxable portfolios.

  • Offsetting capital gains: A critical assumption is that the client will have realized gains to offset; realized capital losses can only offset a small amount of ordinary income each year.

  • Capital losses only delay the tax bill: Harvesting strategies may delay taxes, but eventually most clients will pay taxes on their appreciated securities, unless they gift the securities to charity or leave them to beneficiaries who receive a step-up in basis at death.

  • Tax planning is critical: Clients who expect to be in higher tax brackets in the future may want to accelerate rather than delay gain realization.

  • Loss harvesting results typically decline over time: Unless cash is regularly added to a portfolio, a strategy of selling “losers” while holding on to “winners” often leads to a portfolio filled with stocks held at gains, limiting the opportunity to take losses. The best results in a tax loss harvesting strategy are often found in the first five years.

Beware of Inflated Claims

We’ve noted with a mix of amusement and consternation lofty claims about the effectiveness of tax loss harvesting from some online advisors (also known as robo-advisors). Although we are proponents for harvesting strategies, some of the claims we’ve seen are unrealistic given our more than a decade of experience managing tax loss harvesting portfolios and results we’ve seen from competitors we respect.

The claims made by online advisors arguably represent the triumph of favorably simulated back-tested results over actual experience. Although we believe that back-testing simulations serve an important role in portfolio management, we are skeptical of investment managers who use back-tested results too prominently in their marketing campaigns.

Investor and media attention typically is devoted to high-profile managers with eye-catching returns. This is an understandable fact of life in a headline-driven world, but in our view, performance tends to be hard to predict and few managers deliver market-beating performance over extended periods of time. Taxes are often a “silent killer,” eroding investor returns while getting insufficient attention other than in the days leading up to year end or April 15.

The good news for investors is that they can take steps to manage their tax bill, with a tax loss harvesting strategy being an easy-to-implement, low cost and transparent way to do so. —Daniel S. Kern