The tax code is filled with special provisions for investors that can help lower their tax bill. Some are common, while others are more obscure, but all of them can save valuable tax dollars in the right circumstances. In this three-part series, we will discuss nine tax breaks for investors.
1. Passive Activity Losses
Passive activity loss rules can be both confusing and difficult to track, but they can also bring substantial tax savings in the right situations. Essentially, any loss resulting from rental activity – such as the rental of investment property – generates passive activity losses, unless an exception is met.
The exception allows an individual to take a loss of up to $25,000 from rental real estate without needing other passive income to offset it. This exception is available only to non-real estate professionals who own at least a 10 percent interest in the property, actively manage the rental property and meet certain income thresholds. The maximum loss of $25,000 is limited by $1 for every $2 that modified adjusted gross income (MAGI) exceeds $100,000. Once MAGI reaches $150,000, the passive loss is fully phased out for that year. Any non-deductible passive activity loss can be carried forward to future years and is tracked on Form 8582, Passive Activity Loss Limitations.
2. You Own Company Stock Inside a 401(k) or Other Qualified Plan
If you purchased company stock inside either an employee stock ownership or 401(k) plan, you might be able to defer some taxable gains. Special provisions allow you to transfer the company stock from inside one qualified plan into a private taxable account without paying tax on the fair market value of the stock. Instead, you pay tax only on the amount you originally paid for the shares and defer the tax on any appreciation until you sell the stock at a later date.
You can also save even more money if you hold the company stock long-term (more than one year). In this case, you would pay tax only on your gain at the lower capital gains rates. If you sold the stock and took distributions out of your 401(k) plan, you would have to pay tax at your ordinary income rate, which is usually higher. Essentially, you win twice with owning company stock in a qualified plan. First, when are allowed to defer your appreciation; and again, when you pay taxes at the lower capital gains rates.
3. Donating Appreciated Stock
Do you donate to charitable organizations? If so, do you usually make your donation in the form of cash? If this is the case, you might want to consider donating some stock investments to your favorite organization this year instead.
When you donate appreciated stock to a charitable organization, you are allowed to deduct the full fair market value of the investment at the date you make your donation. This means that you not only realize the tax savings of your donation, but you also avoid paying tax on any gain you have in the investment.
Here is an example of how this works. Say you purchased a stock for $1,000 and today it is worth $2,000. If you donate the appreciated stock directly, you get to claim a deduction for $2,000. If you sold the stock first, you would have to pay tax on the gain of $1,000. Assuming you are in the 25 percent tax bracket and the gain is short term, you would net only $1,750 to donate and deduct. If you already plan on making a donation, you might want to consider donating appreciated stock and holding onto your cash instead.
If you want to take advantage of this tax savings strategy, there are a couple of things to remember. First, you have to complete the transfer of ownership before Dec. 31 of the year you want to claim the deduction. Second, this strategy works only with investments held in regular taxable accounts.
These are just a few examples of special tax strategies available to investors. In the next part of this series, we will discuss three more potential opportunities. If you think any of these examples apply to your situation, contact a tax professional who will help you take advantage of these opportunities.