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There’s still ample time in 2015 to rearrange the timing of your investments, trading, retirement and business affairs to improve your overall taxes for 2015 and surrounding years.
Tax planning may be challenging, but it pays off
With plenty of moving parts, graduated tax rates and a long list of loopholes, tax breaks and penalties, you’ll need extra diligence for tax planning this year. Upper-income individuals must contend with AMT, Obamacare NIT and AGI-based phase-outs of tax breaks on itemized deductions, personal exemptions and credits.
We focus on traders, investors and investment managers and with volatile financial markets in 2015, many experienced wide swings in income and losses. Several face an unfamiliar tax landscape, such as much higher income and not realizing or setting aside higher taxes with surprises like Obamacare NIT; or huge losses, missing a timely Section 475 election for business ordinary loss treatment and getting stuck with significant capital loss carryovers.
Traders have special issues to contend with
Wash sales: Securities traders must comply with onerous wash sale loss rules (Section 1091) and brokers make it more difficult for them by applying different rules from taxpayers on tax reports and Form 1099-Bs. Taxpayers must report wash sales on substantially identical positions across all accounts, whereas brokers report only identical positions per account. Use TradeLog to identify potential wash-sale loss problems. Break the chain by selling the position before year-end and not buying a substantially identical position back 30 days before or after in any of your individual taxable or IRA accounts. (Starting a new entity effective Jan. 1, 2016 can break the chain on individual account wash sales at year-end 2015 providing you don’t purposely avoid wash sales with the related party entity.)
Section 475 elections: Business traders qualifying for trader tax status like Section 475 on securities for exemption from wash-sale rules and capital loss limitations. Section 475 ordinary losses contribute to NOL refunds. Individuals and existing partnerships can elect Section 475 by April 15, 2016 for 2016 (March 15 for S-Corps).
Trading entities: A “new taxpayer” entity can elect Section 475 within 75 days of inception. Consider that for 2015, especially later in the year. But it’s too late to form a new trading entity by late November and still qualify for trader tax status in that short period before year-end. Unlock employee benefit plan deductions for traders with an S-Corp trading company or C-Corp management company with a trading partnership. Sole proprietor traders can’t have employee-benefit plan deductions since trading income is not self-employment income (SEI). An entity formed late in the year can unlock employee-benefit plan deductions for an entire year by paying officer wages in December.
Trader tax status (TTS): If you qualify for TTS (business expense treatment — no election needed) in 2015, accelerate trading expenses into that qualification period as a sole proprietor or entity. If you won’t qualify until 2016, defer trading expenses until then. You may also capitalize and amortize Section 195 startup costs in the new business, going back six months before commencement. Business expense treatment is far better than investment expense treatment. Investment expenses are part of miscellaneous itemized deductions which are only deductible in excess 2% of adjusted gross income (AGI) and are non-deductible for AMT. If you are stuck with investment expense treatment, try to bunch expenses into one useful year rather than two. The bunching strategy may also be effective for medical expenses and other itemized deductions.
Fill the gaps in tax brackets
If you own an investment portfolio, you have the opportunity to do tax loss selling or the reverse by selling winning positions for capital gains.
Traders like to study investment charts, and they should also study the IRS charts for tax rates with graduated tax brackets, Social Security and retirement contribution limits, standard deductions, exemptions and more. See Tax Rates and other tax charts in our Tax Center. There are significant differences in the charts for filing status: single, married filing joint, married filing separate and head of household. Did you change your filing status in 2015?
Focus on the ordinary income and long-term capital gains brackets. Consider accelerating income and deferring expenses to fill a gap in a bracket before entering the next higher tax bracket. Or, defer income and accelerate expenses to drop down a marginal tax bracket. Just keep an eye out for triggering AMT, a minimum tax rate.
Miscellaneous considerations for individuals
- Note inflation adjustment increases to rate brackets and more.
- Consider your time-value of money when considering acceleration or deferral of tax payments.
- Consider estimated tax payment rules including the safe-harbor exceptions. If you accelerate income, you may need to pay Q4 2015 estimated taxes by Jan. 15, 2016.
- Alternatively, increase tax withholding on wages to avoid estimated tax underpayment penalties.
- If you still need to avoid estimated tax underpayment penalties, arrange a rollover distribution from a qualified retirement plan with significant tax withholding before year-end. Next, rollover the gross amount into a Rollover IRA. The result is zero income and avoidance of an estimated tax penalty.
- Consider year-end gifts of appreciated property to family members within the annual gift exclusions ($14,000 for 2015) to shift income. Consider the “kiddie tax” rules.
- Sell off passive loss activities to unlock and utilize suspended passive-activity losses.
- Maximize contributions to retirement plans.
- The IRS has many obstacles to deferring income including passive-activity loss rules, a requirement that certain taxpayers use the accrual method of accounting, and limitations on certain itemized deductions like investment interest expense and charitable contributions.
- Individuals on the cash method get credit for purchases charged to their credit card by Dec. 31.
Long-term capital gains rates are lower than most people think
If you are married filing joint and your taxable income is under the 2015 15% ordinary bracket $74,900 maximum, you have zero federal taxes on long-term capital gains income. For example, if your taxable income is $60,000, you can sell a security held over 12 months for a $14,900 long-term capital gain and not pay any additional federal tax on that capital gain. (For a single filer, the corresponding 2015 15% ordinary bracket maximum is $37,450 of taxable income.)
Long-term capital gain graduated rate brackets:
Zero for the 10% and 15% ordinary rates,
15% above the 15% ordinary rate, except,
20% in the 39.6% top ordinary rate.
Match short-term vs. long-term capital gains and losses
It’s not tax efficient to do “tax-loss selling” on short-term positions while eating into lower long-term capital gain rate benefits — in other words, to offset short-term capital losses against long-term capital gains. The IRS rules for accounting for the two separate buckets can be confusing. Read last year’s tax planning blog 2014 year-end tax planning for traders point #10.
Qualified dividends are taxed at long-term capital gains rates
Another beauty left over from the Bush-era tax cuts is the rule for qualified dividends taxed at lower long-term capital gains rates: A fiscal incentive was given to long-term investors who hold dividend-paying stocks. As pointed out above, the long-term capital gains rate tax break transcends all tax brackets; it’s not just for the upper-income.
How to qualify: To be a qualified dividend, the dividend must be paid from a domestic corporation or certain (“qualified”) foreign corporation. The taxpayer must hold common stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. For preferred stock, the holding period is 90 days during the 180-day period beginning 90 days before the stock’s ex-dividend date.
The long-term capital gains rate affects futures trading, too
Section 1256 contracts (including futures, broad-based indexes and non-equity options) are subject to 60/40 capital gains tax rates and mark-to-market accounting: 60% is long-term even on day trades and 40% is short-term taxed at ordinary rates. The blended 60/40 rate in the top bracket is 28%. That’s 12% less than the top ordinary rate of 39.6%.
With zero long-term rates in the 10% and 15% ordinary brackets, there is meaningful tax rate reduction throughout the brackets. In the 15% ordinary tax bracket, the blended 60/40 rate is 6%. (Here’s the math: 60% LT x 0% LT rate = 0%. Plus, 40% ST x 15% ST rate = 6%.) In the 10% ordinary tax bracket, the blended 60/40 rate is 4%. States don’t apply a long-term rate, so regular state tax rates apply. Tax Foundation has a useful chart on top federal and state capital gains tax rates.
Instead of day or swing trading the Nasdaq 100 ETF (Nasdaq: QQQ) taxed as a security at ordinary rates, consider trading the Nasdaq 100 emini index (CME: NQ), a Section 1256 contract taxed at lower 60/40 tax rates. There’s also a Section 1256 loss carry back election allowed to apply the loss in the prior three tax years against Section 1256 gains only.
AGI-based phase-outs and tax rates
It’s not always evident whether it’s better to defer or accelerate income, loss and expenses. Consider AGI-based phaseouts of various tax breaks and effective use of marginal tax brackets in the current and surrounding years.
AGI-based phaseouts include the 2% AGI threshold for miscellaneous itemized deductions, which includes investment expenses, the Pease itemized deduction limitation on upper-income taxpayers, child and dependent care tax credits, higher education tax credits, deductions for student loan interest and allowed deductible IRA contribution limits.
Alternative tax regimes NIT and AMT
The Patient Protection and Affordable Care Act has many new and different types of taxes to finance the law, starting on different dates. One of these new tax regimes — the “Net Investment Income Tax” (NIT) originally referred to as “ObamaCare 3.8% Medicare surtax on unearned income” — affects upper-income taxpayers as of Jan. 1, 2013. It only applies to individuals with net investment income (NII) and modified AGI exceeding $200,000 (single), $250,000 (married filing jointly) or $125,000 (married filing separately). (Modified AGI means U.S. residents abroad must add back any foreign earned income exclusion reported on Form 2555.) The tax also applies to irrevocable trusts (and estates) on the undistributed NII in excess of the dollar amount at which the highest tax bracket for trusts begins (this amount is $12,300 in 2015).
Try to defer income and accelerate expenses to reduce MAGI under the NIT threshold above. In calculating NII, deduct properly allocated expenses including but not limited to trading and investment expenses. If you are stuck over the MAGI threshold, try to reduce NII to reduce NIT. There’s also a 0.9% Medicare tax that applies to individuals receiving wages in excess of $200,000 ($250,000 for married couples filing jointly and $125,000 for married couples filing separately).
If you are in a lower income situation and purchase health insurance on an Obamacare exchange, consider how deferral or acceleration of income might affect your current and subsequent year exchange subsidies on Form 8962 (Premium Tax Credit). You don’t want to owe expensive subsidies back to Treasury.
The Alternative Minimum Tax (AMT) was enacted in 1982. Originally intended as a second tax regime to prevent the rich from avoiding most income tax, with lack of indexing for inflation, AMT has exploded on the upper middle-class, too. The AMT rates are 26% and 28%, which are not bad compared to the top regular income tax rate of 39.6%. Many tax advisors suggest that upper income individuals enjoy the AMT rate and accelerate income to pay 28% rates when they can, rather than higher ordinary tax rates. Just don’t bother accelerating deductions that are non-deductible for AMT (as preferences). AMT preferences include real estate and property taxes, state income taxes, miscellaneous itemized deductions and personal exemption deductions. Medical expenses are calculated in a more restrictive way for AMT for taxpayers over age 65. Congress passed the AMT patch (inflation adjustment) for 2015 earlier in the year, rather than wait until year-end as is par for their course.
Will Congress renew lapsed tax extenders?
There’s a long list of temporary tax breaks that Congress can’t afford to write into permanent tax law, even with a sunset provision since it would bust the budget. Each year, Congress has dealt with this mini-fiscal cliff to renew these so-called “tax extenders.”
Per Thomson Reuters, “These tax breaks include, for individuals: the option to deduct state and local sales and use taxes instead of state and local income taxes; the above-the-line-deduction for qualified higher education expenses; tax-free IRA distributions for charitable purposes by those age 70-1/2 or older; and the exclusion for up-to-$2 million of mortgage debt forgiveness on a principal residence. For businesses, tax breaks that expired at the end of last year and may be retroactively reinstated and extended include: 50% bonus first year depreciation for most new machinery, equipment and software; the $500,000 annual expensing limitation; the research tax credit; and the 15-year write off for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property.”
They lapsed at year-end 2014 and I suspect Congress will renew them again around year-end 2015. Perhaps a GOP-led Congress won’t want to affect the 2016 presidential and Congressional elections by upsetting so many taxpayers without a renewal. Neither will President Obama and Democrats. Tax reform is more important and a bigger issue which can include tax extenders but it’s doubtful Congress can address tax reform until 2017 when the next Congress and President take office
Consult your tax advisor
If your tax planning is complex, consider having your CPA prepare a draft tax return to weigh the different “what if” scenarios and options. Many CPAs like our firm use professional tax planning software making the process easier and more effective. If you are a securities trader, run TradeLog accounting software year to date and use its Potential Wash Sale Loss report to avoid wash-sale loss conditions at year-end. Give your CPA a chance to save you some big bucks!
Stay tuned in the next couple days for more blog posts with helpful advice for 2015!