Tag Archives: FI for Beginners

Tax Loss Harvesting

If you have individual stocks or other securities that have a loss in them, you may have a tax planning opportunity: tax loss harvesting.

First off, it is important to keep in mind that tax loss harvesting only applies to assets (such as stocks, bonds, mutual funds, ETFs, etc.) in taxable accounts. It does not apply to assets in retirement accounts and health savings accounts.

If you have assets in taxable accounts that have declined in value relative to your purchase price, you have an opportunity to tax loss harvest. Here’s a basic example:

Example 1: Mark purchased 100 shares of Kramerica stock two years ago for $100 a share ($10,000 total). Based on a disappointing test of an oil-tanker bladder system, Kramerica’s stock is now worth $70 per share. If Mark sells all 100 shares for $70, his total basis in the stock ($10,000) exceeds the amount he realizes on the sale ($7,000) by $3,000.

In Mark’s case, he has a $3,000 capital loss for tax purposes. Capital gains and losses from the sale of property (for most individuals, from securities) are different for tax purposes than other types of income, such as wages, rents, self-employment income, interest, and dividends (collectively, usually referred to as “ordinary income”). Federal income tax law does two things to capital gains and losses. First, it taxes capital gains at a lower tax rate than most other types of income. Second, and most importantly for the purposes of tax loss harvesting, it limits the ability of a capital loss to offset ordinary income.

Capital losses, such as Mark’s loss on Kramerica stock, can offset either capital gains or ordinary income, but only to the extent of $3,000 ($1,500 if the taxpayer files married filing separate) of ordinary income a year.

Thus, tax loss harvesting is a great play in two situations:

  1. A taxpayer has a large capital gain in a taxable year; and,
  2. A taxpayer has ordinary income and can trigger a $3,000 capital loss.

A second example can illustrate the first situation.

Example 2: Lucy sells stock with a historic cost basis of $30,000 for $50,000 in March. Thus, she will have to report a $20,000 capital gain on her tax return. If, however, Lucy has another stock/bond/mutual fund/ETF with a historic cost of $100,000 and a fair market value of $80,000, and she sells it by year-end, she will harvest the $20,000 loss in time to offset the previous $20,000 gain.

Taxpayers with significant capital gains during a year should review their taxable accounts towards year-end to see if there are any opportunities to harvest losses and offset existing capital gains.

For those taxpayers without capital gains, there still can be some opportunity to tax loss harvest.

Example 3: Edward anticipates making approximately $100,000 in 2021 in wages from his employer. If Edward can identify a stock/bond/mutual-fund/ETF with a built-in loss, he can sell the security and reduce his taxable income up to the lesser of the loss or $3,000 in 2021. If Edward owns the XYZ mutual fund with a historic basis of $5,000 and a current value of $2,000, he can sell it before year-end and reduce his taxable ordinary income from approximately $100,000 to approximately $97,000. The capital loss deduction is one taken on the first page of the Form 1040 and is not an “itemized deduction.” Thus, Edward gets the deduction regardless of whether he itemizes his deductions.

Note that Edward is limited in his ability to deduct capital losses in any one taxable year to $3,000. Let’s slightly revise the previous example.

Example 3A: The facts are the same as in Example 3, except the the stock Edward sells has a basis of $10,000. Thus, Edward’s current year capital loss is $8,000 ($10,000 basis less $2,000 sales price) instead of $3,000. However, Edward still can only deduct $3,000 because of the limit on taking capital losses against ordinary income. Thus, Edward’s 2021 taxable income is still approximately $97,000.

Edward can carry forward the excess unused capital loss ($5,000, which is the $8,000 actual loss less the $3,000 used loss) into future tax years. Thus, in 2022, he can offset capital gains and up to $3,000 of ordinary income by the $5,000 capital loss carried forward. If Edward has no capital gains or losses in 2022, he can deduct $3,000 of the $5,000 against his 2022 ordinary income, and then carryforward a $2,000 capital loss into 2023. Edward carries forward the capital loss until it is fully used.

Wash Sales

Tax loss harvesting sounds great, right? But with tax, there’s almost always a catch, and one exists here. The so-called “wash sale” rules.

They are best understood by understanding the concern they address. Say in our first Example Mark sells his 100 shares of Kramerica stock on December 15th to trigger the capital loss. Then on December 16th Mark buys 100 shares of Kramerica stock. Absent the wash sale rules, Mark has had no change in his overall economic position (he still owns 100 shares of Kramerica) yet he’s realized a $3,000 capital loss for tax purposes.

The wash sale rules step in to prevent this sort of gamesmanship. They disallow any loss on the sale of securities when the taxpayer buys the same or similar securities within the period starting 30 days before the loss sale and going through 30 days after the loss sale. The rule applies broadly. It applies to similar securities — for example, selling Vanguard’s S&P 500 index mutual fund at a loss and buying Fidelity’s S&P 500 index mutual fund. It applies to purchases of the same or similar securities by the taxpayer, the taxpayer’s spouse, and by entities controlled by the taxpayer and the taxpayer’s spouse. It can also potentially apply to purchases inside retirement accounts. The wash sale rule also bites to the extent of shares purchased through a dividend reinvestment program where the reinvestment occurs within the 61 day window described above.

Conclusion

Tax loss harvesting provides taxpayers a great opportunity to offset capital gains and possibly up to $3,000 of ordinary income. To work effectively for 2021, taxpayers must sell loss securities by December 31st and must be careful to avoid repurchasing the same or similar securities in a manner that triggers the wash sale rules and disallows the capital loss.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Tax-Efficient Charitable Giving

Introduction

Charitable giving is fantastic! Why not give some of your assets to improve a part of our world? And while you’re at it, why not save a few bucks in income taxes? As is to be expected, this requires some thoughtfulness. For some people, this can drive significant tax savings.

Lay of the Land after Tax Reform

The December 2017 tax reform legislation (often referred to as “tax reform,” the Tax Cuts and Jobs Act, or “TCJA”) significantly altered the landscape for claiming itemized deductions. For 2017, before tax reform became effective, the standard deduction for single taxpayers was $6,350 and $12,700 for married filing joint (“MFJ”) taxpayers. Thus, in order to claim itemized deductions, the taxpayer’s total itemized deductions (such as mortgage interest, state and local taxes, and charitable contributions) had to exceed these thresholds for the 2017 tax year. Many itemized simply because their state tax withholding alone put them in a position to equal or exceed these thresholds. This matters with respect to charitable contributions because if you don’t itemize, you don’t get any tax benefit for your charitable contributions.

Post tax reform, things are different. First, tax reform significantly increased the standard deduction. In 2018 the standard deduction increased to $12,000 for single taxpayers and $24,000 for MFJ taxpayers. Second, the deductible amount of state and local taxes (including individual income and property taxes) is capped at $10,000 per tax return. Thus, for MFJ filers and who paid $10,000 or more in state and local taxes still need $14,001 more in itemized deductions (mostly mortgage interest and charitable contributions) to itemize.

Thus, many will now find that they will take the standard deduction instead of itemizing. The downside is losing the tax benefits of charitable contributions. However, there are several planning opportunities whereby taxpayers can still reap significant income tax benefits of charitable contributions.

Donor Advised Fund (“DAF”)

Ideal for: People (a) with standard deductions very close to their itemized deduction amount or greater and (b) who makes regular, predictable (weekly, monthly, quarterly, or yearly) donations to charities or plan to donate to charities in the future.

How it Works and Tax Benefits: A donor establishes a donor advised fund with a financial institution that has established a charitable institution for the purpose of managing donor advised funds. The donor provides assets to the DAF. Then the donor “advises the fund,” meaning that he or she requests that the fund make disbursements to particular charities in particular amounts. While the institution in control of the DAF could, theoretically, reject the request, as a practical matter as long as the requested charity is a valid, properly registered section 501(c)(3) public charity, the DAF will send money to the charity. There is no explicit time requirement for the DAF to disburse its funds, and thus the DAF can make donations to public charities for several years.

The DAF gives the donor a significant tax benefit in today’s high standard deduction environment. The donor receives an upfront tax deduction for the fair market value of the assets contributed to the DAF in the year of the contribution. It is a way for a donor to bring forward, for tax purposes, the charitable deduction for contributions to a charity or charities occurring over several years. For tax purposes, the DAF aggregates several years’ worth of charitable contributions in a single year without a future tax cost, since the donor is covered by the high standard deduction in the later years when the DAF contributes to the charities.  

Example: Jane and Joe Smith attend Mass every Sunday at St. Joseph’s Catholic Church. Every time they attend Mass they put money in the collection basket as a charitable donation. In November 2018 Jane and Joe add up their projected 2018 itemized deductions (mortgage interest, state taxes, and charitable contributions) and project that they are at $24,000, exactly the same as the standard deduction. They anticipate their itemized deductions in 2019 will only be $18,000. If they make a $5,000 contribution to a DAF in early December 2018, their 2018 itemized deductions will increase to $29,000. Going forward until the DAF is exhausted, the DAF will make disbursements to St. Joseph’s instead of the Smiths making the contributions.

The contribution to the DAF provides the Smiths a significant tax benefit in 2018 ($5,000 reduction to taxable income) and will cost them nothing in 2019, since they will take the standard deduction for 2019 regardless. Forgoing 2019 tax deductions (by accelerating them to 2018 through the DAF contribution) did not cost Jane and Joe Smith any additional tax in 2019 and saved them tax in 2018.

If Jane and Joe were initially at $18,000 in 2018 itemized deductions instead of at $24,000, a $5,000 DAF contribution would not have made sense, because the Smiths would not have enough itemized deductions ($23,000) to exceed the standard deduction.  

Another DAF tax benefit for the donor is that income earned by the DAF (i.e., interest, dividends, and capital gains) is not taxable to the donor. That income increases the charitable impact of the original DAF contribution.

Some caveats: First, a transfer to a donor advised fund is an irrevocable transfer. While the donor retains the right to advise the DAF regarding disbursements to charities, the donor cannot reclaim the funds for him or herself. Second, the institution holding the DAF will charge fees against the DAF assets. Finally, institutions usually require a minimum initial contribution in order to form a DAF.

Donation of Appreciated Stock

Ideal for: Charitably inclined people owning appreciated stock, bonds, ETFs, or mutual funds.

How It Works and Tax Benefits: Donations of appreciated securities to an eligible charity allow the donor to deduct the entire FMV of the stock, up to 30% of adjusted gross income (“AGI”). Alternatively the donor can elect to deduct the basis of the stock, up to 60% of AGI. Further, the donor avoids recognizing the capital gain on the securities on his or her tax return. Thus, this strategy has a benefit from an income perspective (avoids recognition of a gain) and a benefit from a deduction perspective (the itemized charitable deduction).

For those looking to get rid of securities that no longer fit their desired investment portfolio, this can be a very tax efficient manner to do so.

Note that built-in loss securities should not be donated to charities. Rather, they should be sold first in order to trigger the capital loss for tax purposes, and then the proceeds should be donated to the charity.

Hyper Donor Advised Fund

Ideal for: Charitably inclined people owning appreciated stock, bonds, ETFs, or mutual funds that make routine charitable contributions or are interested in making future charitable contributions.

How It Works and Tax Benefits: The “hyper donor advised fund” (my pet name for this technique) simply combines the first two planning techniques.

Here is an example: Sammy owns 100 shares of Kramerica Industries. It is worth $50 per share ($5,000 total) and Sammy paid $5 per share ($500 total). Sammy has determined that he will have $11,000 of itemized deductions in 2018 and is likely to have no more than that in 2019 and 2020. Sammy plans to donate approximately $1,000 to his favorite charity, The Human Fund, annually.

Sammy can transfer the appreciated Kramerica stock to a DAF in December, 2018 and claim $16,000 of itemized deductions on his 2018 tax return without lowering his tax deductions in 2019 and 2020. Sammy also avoids recognizing on a tax return the $4,500 ($5,000 less $500 cost basis) gain he has in the Kramerica stock. The DAF can sell the Kramerica stock, invest the proceeds, and make, at Sammy’s recommendation, annual donations to The Human Fund.

Qualified Charitable Distribution (“QCD”)

Ideal for: (a) those 70 ½ or older and (b) those nearing age 70 ½ who cannot yet do a QCD, but should consider future QCDs when doing current tax planning.

How it Works and Tax Benefits: Donors 70 ½ years old and older can contribute up to $100,000 annually to charity directly from their traditional IRA without the amounts contributed being included in taxable income. The main advantage of this strategy is that the taxpayer’s “required minimum distribution” (“RMD”) can be satisfied by the QCD without a taxable income inclusion to the donor. While the donor does not receive a charitable deduction, that is made up for by excluding the amount of the QCD from taxable income. Given the new higher standard deduction, the taxpayer essentially gets the benefit of a charitable deduction without having to itemize.

While the QCD can satisfy the RMD, it does not have to – if a taxpayer has a RMD of $10,000 for the year but wants to make a $20,000 donation from their IRA to a charity, they can do so and the entire $20,000 amount qualifies for QCD treatment.

QCDs also present a planning opportunity for those not yet 70 ½ years old. Many do Roth Conversions (converting traditional IRAs and other traditional accounts to Roth IRAs) prior to age 70 ½ to reduce future RMDs. Doing so creates current taxable income, but lowers the future balance in the traditional IRA or 401(k) such that in the future RMDs are lower. For those charitably inclined, they may want to limit current Roth Conversions designed to mitigate future RMDs, since future QCDs can be used to eliminate the tax impact of RMDs in the future. Thus, charitably inclined individuals in their 60s may want to leave some amounts in traditional IRAs for future charitable donations. Then, when they turn 70 ½ they can make QCDs to avoid RMD taxable income.

It is important to note that to qualify for QCD treatment, the donor must be 70 ½ or older on the date of the distribution. Second, gifts to private foundations and DAFs do not qualify for QCD treatment. Third, inherited IRAs qualify for QCDs as long as the beneficiary inheriting the IRA is 70 ½ or older at the time of the distribution.

Lastly, the charity should never give any token gift of appreciation for the QCD donation because the receipt of anything in return for the donation disqualifies the distribution from favorable QCD tax treatment.

Bunching Contributions

Ideal for: Charitably inclined people with excess cash at year end.

How it Works and Tax Benefits: For taxpayers at or over the standard deduction threshold near year end, it may be advisable to make next year’s planned charitable donations this year to accelerate the tax deduction and take advantage of the next year’s higher standard deduction. Similar to some of the above techniques, the technique picks a year to itemize deduction and then picks a year (or years) to utilize the standard deduction in a manner the optimizes the total tax deductions taken over a period of time.

Charitable Remainder Trust

Ideal for: Wealthy charitably inclined people looking for a large current tax deduction, often in cases where they have a one-time significant income event, such as the sale of a significant asset or business or a very significant bonus.

How it Works and Tax Benefits: Taxpayers can contribute assets to a trust whereby the donor receives the income from the trust assets for a period of time and a designated charity receives the assets of the trust at the end of a period of years. This technique gives the donor a large upfront one-time deduction based on IRS rules.

This is generally not a strategy very applicable in the FI community, but for certain wealthy taxpayers looking for a significant tax deduction and willing to engage the right legal and tax professionals, it can create significant benefits.

Conclusion

Charitable giving illustrates the need to always consider whether there is a tax angle to a transaction. Contributions, if structured in particular way, can provide significant tax benefits while fulfilling their main purpose — the improvement of society and the advancement of the charity’s eleemosynary cause.  

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

Section 199A for Beginners

Introduction

Tax is a crucial consideration for those with small businesses and side hustles. A new tax provision, Section 199A, passed as part of Tax Reform in December 2017, gives many small business owners and side hustlers a deduction determined with respect to their “qualified business income” (or “QBI”).

So what’s going on? Why would you get a tax deduction for a certain type of income? The short answer is that the Section 199A deduction was needed to help level the playing field for small businesses (especially manufacturers) vis-à-vis large corporations. Tax Reform cut taxes for corporations (generally from 35 percent to 21 percent). To keep small businesses, many of which are taxed on individual tax returns at federal rates up to 37 percent, competitive with larger corporations, Congress enacted a partial deduction for qualified business income. The deduction has the effect of lowering the federal income tax rate on that income.

The QBI deduction also applies to so-called Section 199A dividends. Please see the discussion further below regarding Section 199A dividends.

Do I Qualify for the Section 199A Deduction?

The bad news is that, even for a tax rule, Section 199A is incredibly complex. The much better news is that most of that complexity applies to about 10 percent or less of taxpayers. For 90 plus percent of taxpayers, it isn’t too complicated!

To figure out if it is going to be complicated for you, ask yourself one question (all amounts as applicable for 2021):

Is my taxable income $164,900 or less?

If you’re married filing a joint tax return (“MFJ”), change the question to

Is my taxable income $329,800 or less?

For 2020, apply the above questions with $163,300 for single taxpayers and heads of household, and $326,600 for MFJ taxpayers. For 2021, married filing separate taxpayers use $164,925 as their number.

Remember, the key number is taxable income. Taxable income is your adjusted gross income less your standard deduction ($12,550 in 2021 for singles, $18,800 for heads of householder, and $25,100 for MFJ) or your itemized deductions. So if you take the standard deduction, you’re looking at adjusted gross income of $177,450 for singles, $183,725 for heads of household, and $354,900 for MFJ filers. Those are high thresholds for most Americans and for most of those seeking financial independence).

Section 199A Basic Calculation

If you answered Yes to your bolded question, your Section 199A deduction is computed based on a relatively simple (for tax) calculation. Your Section 199A deduction is the lesser of

  1. 20 percent of your taxable income less your “net capital gain” which is generally your capital gains plus your qualified dividend income (“QDI”) or
  2. 20 percent of your QBI.

Here are two examples to illustrate the calculation (all examples avoid discussing self-employment tax for ease of illustration):

Example 1: Phil has $100,000 of W-2 wage income, $1,000 of QDI from mutual funds owned in taxable accounts, makes $10,000 from a trade or business side hustle reported on Schedule C, and claims the standard deduction on his tax return. Phil’s Section 199A deduction is the lesser of

  1. 20% of Phil’s taxable income less net capital gain ($100,000 of wages, plus $1,000 QDI plus $10,000 of QBI less $12,000 standard deduction less $1,000 “net capital gain” – in this case, his QDI – equals $98,000. $98,000 X 20% = $19,600) or
  2. 20% of Phil’s QBI ($10,000 X 20% = $2,000).

Thus, Phil’s Section 199A deduction is $2,000, fully 20 percent of his side hustle income.

Example 2: Mary owns a sole proprietorship engaged in a domestic trade or business which earned $100,000 this year reported on Schedule C. Mary also earned $1,000 of QDI from mutual funds owned in taxable accounts and claims the standard deduction on her tax return. Mary’s Section 199A deduction is the lesser of

  1. 20% of her taxable income less net capital gain ($100,000 of Schedule C income plus $1,000 QDI less $12,000 standard deduction less $1,000 “net capital gain” – in this case, her QDI – equals $88,000. $88,000 X 20% = $17,600) or
  2. 20% of her QBI ($100,000 X 20% = $20,000).

Thus, Mary’s Section 199A deduction is $17,600, 17.6 percent of her sole proprietorship income.

Section 199A is great news for side hustlers and pretty good news for sole proprietors and other owners of flow-through businesses. Why the slight benefit reduction for our sole proprietor? The answer lies in the benefit of the standard deduction (or itemized deductions, if applicable). Since Mary already had the standard deduction protecting some of her QBI from full taxation, the Section 199A deduction was reduced to account for that benefit.

Note that if Mary had another source of income (other than long-term capital gains or qualified dividend income), such as a Roth conversion amount, or a spouse with income, that income would increase her taxable income limitation and she could qualify for up-to the full 20 percent QDI deduction.

What is QBI?

Now that we have the calculation illustrated, we must ask what is “qualified business income” (“QBI”)? Generally, QBI is domestic income from a trade or business (as defined under normal U.S. tax principles) received by a sole proprietor or by an individual from a “flow-through” business (a partnership, LLC, S-corporation, trust, or estate). Some important considerations:

  • QBI does not include wage income (W-2 income).
  • It is important to maintain documentation supporting that the activity is a trade or business.
  • It is important that the activity not be considered a hobby.
  • Rental income from the active conduct of a rental real estate trade or business is QBI. Income from the renting out of buildings where the owner is not engaged in a real estate trade or business is not QBI. Real estate may become a hot-spot for disputes between the IRS and taxpayers.

High Income Taxpayers

What if you answered No to your question? If you have QBI, you’re likely to need the assistance of a qualified tax professional. The rules get complicated quickly. For those with taxable income above $164,900 ($329,800 for MFJ, $164,925 for MFS), their Section 199A deduction is subject to a limitation and possibly a second additional limitation, as follows:

  1. For taxpayers over the taxable income thresholds, all QBI is subject to a limitation on the Section 199A deduction based on W-2 wages paid by the business and the unadjusted asset basis in the business. The more of these attributes, the greater the Section 199A deduction. Note that unadjusted asset basis is generally the acquisition cost of property. It includes tangible property (including buildings) but does not include land.
  2. Income from a specified service trade or business suffers an additional limitation. The Section 199A deduction for such income is phased out for taxable incomes between $164,900 and $214,900 ($329,800 and $429,800 for MFJ filers) (using 2021 numbers).

The preamble to the proposed regulations states that a “specified service trade or business” is (1) any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, and (2) any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities . . . partnership interests, or commodities.”

The general idea behind the specified service trade or business is that Congress wanted to prevent high earning doctors, lawyers, accountants, etc., from benefiting from Section 199A. Congress intended for the benefits to generally go to manufacturers.  Manufacturers will generally find themselves only subject to the first limitation, and many will have buildings and equipment with tax basis and/or will pay significant W-2 wages to employees and thus will not find the limitation to have much effect.

For those subject to these complex limitations, there can be significant benefits from doing planning and restructuring with the assistance of qualified tax advisors to maximize their Section 199A deduction. Such planning can include planning to increase current year tax deductions (through, for example, increased retirement plan contributions) to reduce taxable income below the relevant testing thresholds.

Section 199A Dividends and Income from Publicly Traded Partnerships

Qualified dividends from real estate investment trusts (“REITs”) (Section 199A dividends) and ordinary income from publicly traded partnerships qualify for the Section 199A deduction. There is no need for the taxpayer to be in a trade or business and there are no limitations based on taxable income. In terms of sheer volume, I expect more returns will claim this Section 199A QBI deduction than the QBI deduction for “normal” qualified business income discussed above.

It is important to note that dividends and other income received in tax advantaged accounts (IRAs, 401(k)s, HSAs, other retirement accounts) does not qualify for the Section 199A deduction.

Tax Reporting

Taxpayers report their QBI deduction on either a Form 8995 or a Form 8995-A (for the 2019 tax year and later). Box 5 of Form 1099-DIV (Section 199A dividends) reports the dividends that qualify for the QBI deduction.

Further Reading

I published a more detailed Section 199A post here. It provides more examples of the application of Section 199A.

I published a post discussing the Section 199A QBI deduction and how the concept interacts with small business retirement plans (click here).

I published a post on a potential planning opportunity available to some self-employed individuals to capitalize on the interplay of self-employed income, Roth conversions, and the Section 199A deduction here.


FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This posting is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.