Investment Tax Basics For All Investors

From Investopedia we read: “…nothing can be said to be certain, except death and taxes.” - Benjamin Franklin  The founding father’s famous axiom is as true today as the day he wrote it, which means investors need to understand what the government takes.

The federal government taxes not onlyinvestment income - dividends, interest, rent on real estate, etc. - but also realized capital gains. The taxman is smart, too; investors cannot escape by investing indirectly through mutual funds, exchange-traded funds, REITs or limited partnerships. For tax purposes, these entities are transparent. The tax character of their distributions flows through to investors in proportion to their economic interest, and investors are still liable for tax on capital gains when they sell.

Tax on Dividends
Companies pay dividends out of after-tax profits, which means the taxman has already taken a cut. That’s why shareholders get a break - a preferential tax rate of 15% on “qualified dividends” if the company is domiciled in the U.S. or in a country that has adouble-taxation treaty with the U.S. acceptable to the IRS. Non-qualified dividends - paid by other foreign companies or entities that receive non-qualified income (a dividend paid from interest on bonds held by a mutual fund, for example) - are taxed at regular income tax rates, which are typically higher. In 2013, that's a sliding scale up to 39.6%, plus an additional 3.8% surtax for high-income taxpayers ($200,000 for singles, $250,000 for married couples).

Shareholders benefit from the preferential tax rate only if they have held shares for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date. In addition, any days on which the recipient’s risk of loss is diminished (through a put option, a sale of the same stock short against the box, or the sale of most in-the-money call options, for example) do not count toward the minimum holding period. 

• Case No.1: An investor who pays federal income tax at a marginal 28% rate and receives a qualified $500 dividend on a stock owned in a taxable account for several years owes $75 in tax. If the dividend was non-qualified, or the investor did not meet the minimum holding period, the tax would be $140. A top-rate taxpayer (income tax at 39.6% plus the 3.8% healthcare surtax) would owe $217 tax on a non-qualified dividend.
  Investors can reduce the tax bite if they hold assets, like foreign stocks and taxable bond mutual funds, in a tax-deferred account like an IRA or 401(k) and keep domestic stocks in their regular brokerage account.
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Tax on Interest
The federal government treats most interest as ordinary income subject to tax at whatever marginal rate the investor pays. Even zero-coupon bonds don’t escape. Although investors do not receive any cash until maturity, they must pay tax on the annual interest accrual on these securities, calculated at the yield to maturity at the date of issuance.

The exception? Interest on bonds issued by U.S. states and municipalities, most of which is exempt from federal income tax. Some municipal bonds exempt from regular federal income tax are still subject to the alternative minimum tax, however. Investors should check the federal tax status of any municipal bond before they buy.

Investors may get a break from state income taxes on interest, too. U.S. Treasurysecurities are exempt from state income taxes, while most states do not tax interest on municipal bonds issued by in-state entities.

• Case No.2: An investor who pays federal income tax at a marginal 33% rate and receives $1,000 semi-annual interest on $40,000 principal amount of a 5% corporate bond owes $330 in tax, leaving $670. If the same investor receives $800 interest on $40,000 principal amount of a 4% tax-exempt municipal bond, no federal tax is due, leaving the $800 intact. Even a top-rate taxpayer would owe neither federal income tax nor the healthcare surtax. Investors subject to higher tax brackets often prefer to hold municipal bonds rather than other bonds in their taxable accounts. Even though municipalities pay lower nominal interest rates than corporations of equivalent credit quality, the after-tax return to these investors is usually higher on tax-exempt bonds.
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Tax on Capital Gains
Uncle Sam’s levy on realized capital gains depends on how long an investor held the security. The tax rate on long-term (more than one year) gains is 15%, except for high-income taxpayers (in 2013, $400,000 for singles, $450,000 for married couples) who must pay 20%. High-rate taxpayers will typically pay the healthcare surtax as well, for an all-in rate of 23.8%.

Just like the holding period for qualified dividends, days do not count if the investor has diminished the risk using options or short sales (see above).

Short-term (less than one year of valid holding period) capital gains are taxed at regular income tax rates. 

• Case No.3: An investor in the 25% tax bracket sells 100 shares of XYZ stock purchased at $50 per share for $80 per share. If he or she owned the stock for more than one year, the tax owed would be $450 (15% of (80 - 50) x 100), compared to $750 tax if the holding period is less than one year. In identical circumstances, a top-rate taxpayer would owe $1,302 on a short-term capital gain vs. $450 on a long-term gain.
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Tax Losses and Wash Sales
Investors may offset capital gains against capital losses realized either in the same tax year or carried forward from previous years. Individuals may deduct up to $3,000 of net capital losses against other taxable income each year, too, while any losses in excess of the allowance are available until either offset against gains in future years or amortized against the annual allowance.

Investors can minimize their capital gains tax liability by harvesting tax losses. If one or more stocks in a portfolio drops below an investor’s cost basis, the investor can sell and realize a capital loss for tax purposes, which will be available to offset capital gains either in the same or a future year.

There’s a catch, however. The IRS treats the sale and repurchase of a “substantially identical” security within 30 days as a “wash sale”, for which the capital loss is disallowed in the current tax year. The loss increases the tax basis of the new position instead, deferring the tax consequence until the stock is sold in a transaction that isn’t a wash sale. A substantially identical security includes the same stock, in-the-money call options or short put options on the same stock, but not stock in another company in the same industry. 

• Case No.4: An investor in the 35% tax bracket sells 100 shares of XYZ stock purchased at $60 per share for $40 per share, realizing a $2,000 loss, and 100 shares of ABC stock purchased at $30 per share for $100 per share, realizing a $7,000 gain. Tax is owed on the $5,000 net gain. The rate depends on the holding period for ABC - $750 for a long-term gain, or $1,750 for a short-term gain. If the investor buys back 100 shares of XYZ within 30 days of the original sale, the capital loss on the wash sale is disallowed and the investor owes tax on the full $7,000 gain - $1,050 for a long-term gain, or $2,450 for a short-term gain.
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The Bottom Line: Taxes Matter
Taxes have a significant impact on the net return to investors. Detailed tax rules are available on the IRS website for dividends and . While careful asset placement and tax-loss harvesting can reduce the tax burden, everyone’s tax circumstances are unique. Investors should consult their own financial and tax advisors to determine the optimum strategy consistent with their investment objectives.for capital gains and wash sales

Original story - Investment Tax Basics For All Investors

Mid-Year Tax Planning When Selling Your Primary Residence

CBS TV writes: When Steven and Robin Fine started searching for a place in Latin America to spend their early retirement, they looked at spots in Mexico and Costa Rica, both popular destinations for American retirees. On a trip two years ago, they decided to stop by Panama, too.

"We thought we would like Panama the least," Mr. Fine, 51 years old, a former communications executive said, "but we liked it the best."

The combination of luxury apartment buildings, good restaurants and modern hospitals drew the couple to Panama City, where 1½ years ago they spent $1.1 million, plus about $250,000 on renovations, on a 48th-floor penthouse with a view of the Pacific. It is now their full-time home.

The Central American nations of Panama, Belize and Nicaragua are increasingly competing with Costa Rica and Mexico for North American retirees and second-home buyers. New luxury developments, outfitted with spas, restaurants, marinas and golf courses, are on the rise. Builders say they are using more high-end materials and adding upscale amenities designed to appeal to affluent American buyers.

These countries offer packages of residency and breaks on taxes and fees that imitate Costa Rica's pensionado program, which was introduced in 1971 and helped set the groundwork for a boom in retiree emigration from North America. Nicaragua added such a law in 2009, offering foreigners with retirement incomes tax breaks on everything from cars to construction materials. Last year, Panama, which has a long-established retiree program, created a path to citizenship for retirement residents and introduced a new residency program for people under retirement age that has lowered requirements for investment in property, business and other ventures.

"The message of this law is simple," said Panama City-based attorney Manoj Chatlani of Panama Offshore Legal Services. "It's 'Come to Panama.' "

The number of Americans who collect Social Security in Panama jumped 65% to 2,164 between 2006 and 2011, the latest year for which there is information. In Nicaragua, the figure more than doubled in the same period, from 595 to 1,322. Belize's number, too tiny for the Social Security Administration to track in years past, was 560 in 2011.

Panama's explosive growth—gross domestic product increased by an average of 8.5% annually since 2008, according to International Monetary Fund estimates—has drawn American workers and businesses to Panama City over the past decade. Now, local developers are courting another population, focusing on building amenity-rich planned communities outside the city to appeal to North American retirees.

Boquete, a town about 40 miles from the Costa Rican border, offers high-end gated communities, an established expat community, cool mountain temperatures and tropical-rainforest landscape. Justin Harper, co-owner of Playa Chiquita Development Corp., is developing about 200 acres of virgin land 20 miles east of Boquete. The community, Bella Vista del Mundo, has 76 lots and plans for a boutique hotel, spa, pools, tennis courts and horseback trails. Single-family homes with mountaintop and Pacific Ocean views can be built by the developer for about $400,000.

David Hatton Urriola, 43, moved to Boquete three years ago from Kansas and set up Panama Connection Real Estate, which provides tours, relocation help and real-estate sales to expats. Among properties he is currently marketing is a 6,716-square-foot house on 34 acres, once used as the summer home of Panama's military leader, Manuel Noriega, who is serving a 20-year sentence in El Renacer prison in Panama City. The house, listed at $2.3 million, is a 25-minute drive from where an international airport is being expanded.

On the east side of Panama City, a 700-acre community called Santa Maria Golf & Country Club is being built to include 4,000 colonial-style houses, townhouses and condominiums, and a golf course designed by Jack Nicklaus's company. The homes, yet to be completed, sell for about $278 a square foot, a "top price" in Panama City, said Kent Davis, broker at Panama Equity Real Estate.

"Santa Maria is a product that hadn't existed in Panama before: the luxury suburban community—more American-style larger lots," Mr. Davis said. Most pre-delivery buyers have been Panamanians; local agents say they expect American interest to rise as the development nears completion in five to 10 years.

Belize, a small, English-speaking nation with a population of about 330,000, has been popular for years as a scuba-diving and ecotourism destination. High-end properties had to be custom-built until the early 2000s, when developers started putting up "single homes here and there," said Hugo Moguel, president of the Association of Real Estate Brokers of Belize, which is launching the country's first multiple-listing service in August.

Now, developers are attempting to sell Belize as a luxury-living place to retire. New developments include Sanctuary Belize, a 14,000-acre development slated for completion in three years that will have 2,000 residential lots, 250 condominiums and townhouses, and a 220- to 250-slip marina. The buildings' poured-concrete construction meets Dade County, Fla., hurricane-resistant standards, said Luke Chadwick, a partner in Eco-Futures Development. Developer financing is available.

Of the 600 lots Sanctuary has sold so far, 80% of them have been to Americans, he said. The core demographic is "50 to 65 year olds, either in retirement or planning for retirement," Mr. Chadwick added. Lot prices range from $149,000 to $1 million for an acre overlooking the Caribbean, he said.

Tom and Tricia Herskowitz moved into their 7,000-square-foot compound in Sanctuary this past September, lured by the boat slip and Caribbean access. "The fact that the country is English speaking and is a Commonwealth country was attractive to us," said Mr. Herskowitz, 68, a retired executive and business-school professor.

Amid growing tourism—and aided by the lowering of a foreigner transaction tax in 2006—there has been a boom in luxury-condo developments, especially on the island of Ambergris Caye, popular with expats.

"There are beachfront condos going up that are going to feature elevators, which didn't exist in Belize before. Most of the buyers are baby boomers and they are aging," said Dmitri Ioudine, owner of Coldwell Banker Ambergris Caye Ltd. Local builders say building materials have improved as local suppliers bring in higher-end materials.

Despite their inroads with American retirees, these countries still don't attract the same numbers as more established destinations, such as Mexico and Costa Rica. In 2011, more than 50,000 Americans collected Social Security in Mexico and more than 5,000 in Costa Rica. But Mexico's well-publicized drug war and escalating violence are starting to push Americans to look at new places for retirement.

Central America, however, has its own problems with crime. The U.S. Department of State labeled the crime rate in Nicaragua "critical" and the murder rate in Belize "extremely high," though concentrated in Belize City and not in tourist areas. In Costa Rica, petty crime such as theft and "smash and grab" muggings have increased in the past couple of years, along with home invasions.

In Panama, murders and gun violence have decreased in recent years, but reported rape and theft have increased. "Panama remains relatively safe when compared with other Central American countries, yet crime rates are higher than one would encounter in most of the United States," says the State Department's 2013 report.

Dan Prescher, who leads conferences by International Living, a provider of information for people interested in retiring abroad, says urban crime rates can exaggerate safety issues in other areas of a country. Still, he warns that public security isn't always adequate in the region.

Nicaragua is the latest country to attempt to grab North American interest. In Guacalito de la Isla, a 16,070-acre coastal development—with 600 residences, a pool, restaurant and gym—is under construction. A two-hour drive from Managua's international airport, the project includes a plan to open a small airport by 2015. The first homes—28 single-family houses—will be turned over to owners in September. The four-bedroom, four-bath pool houses sold for between $700,000 and $750,000, said Jeff Lawrence, director of real estate. A luxury hotel-resort on the property, Mukul, opened in January and has helped boost sales, he said.

"The buyers right now are 85% Nicaraguan and 15% U.S. based," Mr. Lawrence said. "There is an education hurdle for us to convince people that Nicaragua is safe and is a tropical paradise."

When It's Time to Call In the Tax Pros

Arden Dale for the Wall St Journal writes: Advisers who want to help clients cut their taxes aim to know enough about the tax code to recommend a tax or estate strategy, but recognize when to step back and let the tax professionals take over.

When it comes to hatching strategies to reduce income, gift or estate taxes, the small details are what matters. Missteps can land a client in an audit, result in tax penalties, or even put an estate into the hands of the wrong person. So advisers try not to cross into territory better left to accountants and tax attorneys.

For example, it may be obvious that a client ought to sell part of a big stock position, but equally clear that an accountant should help decide whether to sell other shares to net capital gains against losses.

"You know the water's too deep when you need to know intricate technical tax or legal details to make sure the strategy works," said Steven B. Weinstein, president and chief investment officer of Altair Advisers LLC, a Chicago firm that manages $3.4 billion.

Mr. Weinstein recalled dealing with a retired client who had more income than he needed to live on from his role as board director of several companies, and how he easily spotted that a Keogh pension plan would be a good solution. The adviser knew the plan would let the client make a tax-deductible contribution that could grow tax deferred. But it took an accountant, an attorney and an actuary to make it happen.

The fast pace of changes to the federal tax code make it especially important for advisers not to assume anything when they recommend a tax strategy, said Brent Brodeski, chief executive of Savant Capital Management, an advisory firm in Rockford, Ill., with $3.3 billion under management. Mr. Brodeski holds a certified public accountant designation, but no longer practices as one.

"Having an accounting background can help me to understand what I don't know sometimes," he said.

Recently, Mr. Brodeski recommended a donor-advised charitable trust for a client who was tired of running a private foundation he set up a few years earlier after he sold a business. The adviser consulted with the man's attorney to see that the assets in the trust wouldn't be counted in the estate at death.

Meredith Schneider, an adviser in Redwood Shores, Calif., who owns her own firm that manages $40 million, noted that she may come up with questions a client can ask a tax expert, but is careful not to get into any details herself.

Recently, Ms. Schneider suggested that one client, a single mother of two-year-old twins, review her individual retirement account with her estate attorney. In some cases, the adviser knows, naming a trust as the beneficiary of an IRA can be better than listing a minor. The trust takes effect at the client's death, and controls how the money is distributed. But that's a strategy she'd rather have the tax attorney recommend.

"I will never say anything definitively," she said.

Confident advisers feel free to seek advice from other professionals, and "leave their ego at the door to openly collaborate with each other," said James Guarino, a partner and senior wealth adviser at Tewksbury, Mass., firm New Wealth Advisors, which manages around $200 million.

Mr. Guarino, who is also a certified public accountant, said most wealth advisers who aren't accountants or attorneys know when to reach out for assistance on tax matters. Not only does that serve the clients, but advisers may get referrals in return.