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GreenTrader Weblog
GreenTraderTax & GreenTraderFunds
| For some prior posts, please click here to visit our prior blog. We are in the middle of transitioning to our new blog destination at greencompany. Thank you. |
January 10, 2008
“Tax Reduction and Reform Act of 2007” (H.R. 3970)
The “Tax Reduction and Reform Act of 2007” (H.R. 3970) is still on the table. If enacted, it could have profound tax consequences for traders.
By Robert A. Green, CPA
You all know the popular line, “There are two things that are certain in life: death and taxes.”
There is another certainty this coming year and that is that Democrats and Republicans will wage a tax war and make it a key element in defining their differences in connection with the hotly contest 2008 Presidential election.
President Bush and the Republicans have enjoyed eight years of free reign to adopt their tax cuts, including lowering (and hopefully repealing) taxes on savings and investment income (dividends and long-term capital gains).
In November 2006, during the mid-term elections, the Democrats finally won control of both houses of Congress and they took over the bully pulpit.
Newly elected Chairman of the House Ways and Means Committee Charlie Rangel (D.-NY) crafted H.R. 3970, the “Tax Reduction and Reform Act of 2007” (introduced on Oct. 25, 2007).
In H.R. 3970, Chairman Rangel was able to showcase many of the fiscal (tax) values currently advocated by the Democrats.
Political tax maneuvering
First and foremost, Democrats want to cast off their prior image of tax raisers and spenders to become the better party of fiscal conservatism.
Democrats have cried foul about huge increases in the budget deficit since President Bush inherited surpluses from former President Bill Clinton.
The first tax mantra from controlling Democrats after November 2006 was their new creed of “pay go” – paying for tax cuts with tax increases and spending cuts.
Next up were Democratic suggestions for middle-class tax cuts, paid for by tax increases on the rich, with a combination of repeals, expiration of Bush tax cuts and more. Democrats also want some spending cuts, such as in defense and ending the costly Iraq War.
The poster boy for tax change is the Alternative Minimum Tax (AMT) and it’s the cornerstone of the “Tax Reduction and Reform Act of 2007.”
AMT is certainly broken, and taxpayers resent this nasty stealth tax. H.R. 3970 purports to repeal AMT.
Chairman Rangel crafted H.R. 3970 in a clever but antagonizing way to Republican leadership. The bill repeals AMT, but replaces it with new taxes on the rich and many other important repeals and changes.
H.R. 3970 probably has no chance of passage until 2009
President Bush has stated on multiple occasions that he will veto any new tax increases on the rich, specifically the ones in H.R. 3970.
This gives good reason to believe that H.R. 3970 will be effectively “dead on arrival” until there is a new President in the White House in January 2009, assuming Democrats keep control of both the Senate and House.
The last minute AMT patch for 2007 was passed without “pay go”
While H.R. 3970 caused great rancor between the parties, AMT was slated to snag 21 million Americans in 2007, drastically up from only 4 million Americans in 2006.
The structural and simple problem is that AMT is not indexed for inflation, whereas regular taxes are, so AMT bracket creep grabs more middle-class Americans each year.
The perverse problem is that AMT was targeted against the rich, but the rich for the most part no longer pay AMT. That’s because the rich pay so many taxes at the highest tax rates (up to 35 percent in 2007) and the highest AMT rate is far less (up to 28 percent in 2007).
Within just five days of introducing H.R. 3970, Chairman Rangel introduced H.R. 3996, the “Temporary Tax Relief Act of 2007.”
Chairman Rangel included “pay go” in H.R. 3996 (just as he had in H.R. 3970), calling for a repeal of “carried interest” tax breaks for investment managers.
After much fanfare, the Senate sided with the Republicans and President Bush to insist on another annual AMT patch (for 2007), without any new tax increases.
So where do we stand now?
The tax debate was punted down the road and it’s still contained in H.R. 3970, which remains on the table.
So it’s important to focus on the tax changes contained in H.R. 3970.
Current political pundits are forecasting good odds for a Democrat to win the Presidency; probably Senator Obama or Senator Hillary Clinton.
This writer believes that H.R. 3970 was crafted by Chairman Rangel while he was in communication with Senator Hillary Clinton (they both serve in NY and are long-time friends).
If Senator Obama wins the presidency, H.R. 3970 also nicely dovetails with his big tax initiative to expand the payroll tax base significantly or to an unlimited amount. See the S-Corp tax break repeal for owner compensation below.
Higher social security taxes
Senator Obama’s main tax proposal is to significantly expand the social security tax (of 12.4 percent) applied against the base amount ($102,000 in 2008) to a much higher base amount or even unlimited.
This is very similar to changes made in the 1990s, created by then-first lady Hillary Clinton.
In the 1990s, the Medicare tax portion (2.9 percent) of the payroll tax of 15.3 percent was decoupled from the payroll tax base, meaning it applies to an unlimited amount of earned income and wages.
Senator Obama proposes to do a similar change with the social security portion (12.4 percent) – to either raise the base amount significantly or to make it apply to an unlimited amount (phased-in over several years). Expect a firestorm here as well. Raising the base amount only (to a reasonable amount) is more palatable.
Good news for traders: Their trading gains are exempt from these payroll or self-employment (SE) taxes, unless they trade IRC 1256 contracts as a member of an options or futures exchange (in which case it is earned income IRC 1402i).
H.R. 3970 summary of tax law changes
See a summary of H.R. 3970 on the Internet by searching for “HR 3970.”
Repealing AMT entirely is the poster boy for H.R. 3970.
In my view, this is not really a true repeal of AMT.
Rather, it extricates the middle-class from AMT and pays for it with a new “surcharge” and itemized deduction phase-outs on upper-income taxpayers.
Again, upper-income taxpayers were not paying AMT with their higher taxes paid vs. the 28-percent AMT rate and H.R. 3970 cleverly passes the AMT load from middle-income to upper-income taxpayers.
This is a little sneaky. AMT should be repealed for all taxpayers up and down the class-warfare ranks.
AMT was never indexed for inflation, whereas regular taxes are, and this is the fundamental problem with this tax. AMT was passed in the late 1960s to tax the rich who avoided tax with tax shelters, which were subsequently shut down anyway.
AMT is most harshly falling on taxpayers in the $200,000 to $500,000 income range.
Chairman Rangel was very clever in H.R. 3970.
The bill showcases a complete repeal of AMT (what all Americans want), yet the bill subjects upper-income people (10 percent of the highest income taxpayers and/or those earning more than $500,000 in some provisions) to a new tax “surcharge” of 4 percent to 4.6 percent.
It would be fairer to call this an “AMT pass the buck” tax, since this bill clearly passes the current AMT burden on the middle-class to upper-income taxpayers.
Phase-out itemized deductions and exemptions
H.R. 3970 also phases out itemized deductions and personal exemptions for upper-income taxpayers.
Current AMT tax law requires the add-back of several types of itemized deductions to AMT taxable income (like investment interest expense, state taxes and miscellaneous itemized deductions).
The combination of the surcharge tax on upper-income taxpayers above along with this phase-out of itemized deductions again points out how this is truly a passing of the AMT tax buck to upper-income taxpayers.
But there’s good news for business traders: Most of their trading-related expenses are deducted as business expenses and not itemized deductions.
Repeal of the carried interest and deferred compensation tax breaks
Current tax law allows investment managers to receive a “profit allocation” of capital gains rather than investment fees.
Profit allocation or carried-interest gains (depending on the underlying income) can be taxed at lower long-term capital gains tax rates, or with 60/40 futures tax rates, and they are also not subject to payroll/SE taxes.
H.R. 3970 re-characterizes these carried interests as ordinary fee income, which subjects this income to ordinary income tax rates and payroll/SE tax.
The bill also repeals deferred compensation tax breaks for managers of offshore funds and corporations.
Along the same lines, this bill takes away the incentive for U.S. tax-free institutions (such as pension funds, universities and charities) to invest in offshore funds instead of domestic funds. Current tax law subjects them to UBIT taxes on domestic funds only and that will no longer apply with H.R. 3970.
S-Corps can’t reduce SE tax
S-Corps will no longer have an edge in reducing SE tax vs. LLCs, partnerships and sole proprietorships (where SE tax is unavoidable for service companies).
In current law, an owner/manager of an S-Corp in a service business passes through income that is not subject to SE tax. Conversely, with LLCs, partnerships and sole-proprietorships, this earned income passes through to the owner for purposes of SE tax.
S-Corps can’t avoid SE tax entirely. The IRS requires S-Corps to pay reasonable compensation to its owner/managers, which is subject to SE tax.
H.R. 3970 puts S-Corps on a level playing field with LLCs, partnerships and sole proprietorships. All S-Corp earned income will pass through as earned income to owners, whether or not they have a salary or a fee.
This is not very bad news for traders. Their trading gains are not earned income, unless they are a IRC 1256 trader/member of an options or futures exchange. So their S-Corp income can still pass through to their individual tax returns without triggering SE tax.
Business traders can use strategies to create earned income with an entity to have the opportunity to contribute funds to a tax-deductible retirement plan. This is usually done in a way that saves more in income taxes than it costs in payroll/SE taxes.
Money managers face stiff tax increases in H.R. 3970
Under current tax law, many money managers receive profit allocation (carried interest) from their hedge funds, which may be long-term capital gains or 60/40 tax treatment. Plus they don’t currently owe SE tax on the profit allocation income.
H.R. 3970 would repeal carried interest; subjecting this income to higher ordinary income tax rates plus SE tax.
It’s a huge difference.
Currently, a money manager for a commodity fund owes federal taxes at 23 percent (2007 rates) using 60/40.
But with HR 3970, and other expected tax law changes like non-extension of Bush tax rate cuts, the managers taxes may rise by 258 percent to 59.3 percent (44 percent ordinary income tax rates plus 15.3% SE tax, which may be unlimited over time).
Basis reporting by brokers on sales of stock
A very important tax law change for traders in H.R. 3970 are the new rules for significantly expanding the reporting by brokers on securities traders Form 1099-Bs.
This is not an issue for futures traders; their net “Aggregate Profit and Loss” is reported on a one-page Form 1099-B.
But for securities traders the IRS has a huge problem with the lack of current reporting. That’s because current rules only require that brokers report proceeds on the sale of stock. Brokers don’t have to currently report option sales and purchases, securities purchases or gain or loss on securities transactions.
As part of the IRS’s “close the tax gap” initiative, the IRS wants to significantly improve tax information reporting on securities trading activities from brokerage firms by requiring most of the above missing items.
The IRS is rightfully concerned that many securities traders are botching their Schedule D reporting, and usually in their own favor.
In 2005, the IRS made a big stink of clarifying their Schedule D and D-1 instructions that require line-by-line reporting of securities transactions. Far too many traders were reporting one-line item summaries per broker and stating “see details on request.”
The IRS doesn’t trust taxpayers to deal with the tremendous complexities of reporting securities transactions and millions of Americans are trading hyperactively.
H.R. 3970 reinforces several earlier 2007 tax bill initiatives (H.R. 878 and S. 601, and even President Bush’s 2008 Budget) to create mandatory cost basis reporting by brokers for transactions involving publicly traded securities.
The bill also requires brokers to report “adjusted cost basis with FIFO (first in first out) method unless the customer makes an adequate identification to the broker of the shares he sold.”
The bill also requires brokers to report “…whether any gain or loss as a result of the transaction is short- or long term.”
At committee hearings in May, there was much industry criticism about the new reporting burdens this will place on brokerage firms.
Placing undue added burdens on smaller brokerage firms during a possible slow down or recession may be a tough provision to pass. The largest full service brokerage firms already provide their customers with realized gain or loss reports and they will have a much easier time here with enhanced 1099-B reporting.
I believe the new rules will significantly expand what’s reportable to the IRS, but it will fall far short of 100-percent reporting. That means that Form 1099-Bs for securities traders will not provide an adequate report for attaching to a Schedule D.
Securities traders will mostly likely still need good industry third-party software for securities trading gains and losses. Wash-sale reporting must be done across brokerage accounts and brokers can’t do this.
These changes are not scheduled to begin (with phased deployment) until 2009.
One-year extenders & miscellaneous other provisions
As has generally been the case for the past few years, with great gridlock in Congress, H.R. 3970 includes many “One-Year Extenders.”
The tax game seems to be to pass major new legislation when one party dominates all branches of government and to just punt short-term changes down the road until you can hit a home run.
We need more baseball-type singles and lasting legislation that one can count and plan on.
There are some “General Tax Reductions” in HR 3970 too.
The bill has an increase in the standard deduction. This does not help people who itemize their deductions, including mortgage interest, real estate taxes, state income taxes, charitable contributions and miscellaneous deductions (investment expenses). Rather, it mostly helps lower middle-class people.
The bill expands the earned income credit and refundable child credit. This also only helps lower middle-class and the poor.
Lower corporate tax rates
Reducing top corporate tax rates to 30.5 percent from 35 percent was a welcomed surprise from the Democrats in H.R. 3970.
But to pay for it, the bill also captures more taxation on foreign earnings in several ways. That may be a good thing, considering that America’s corporations may be making more profits abroad, with our current slowdown in America underway.
With the growing divergence in individual versus corporate tax rates, many taxpayers may want to reconsider C-Corporations to park more profits in C-Corps taxed at lower tax rates.
Traders usually avoid C-Corps because of double taxation, no 60/40 treatment and other limitations. Adding a C-Corp to the mix, along with an LLC, partnership or S-Corp, may be useful and requires further study.
But is H.R. 3970 going to be a Trojan horse tax trap?
Individual tax rates go up to approximately 44 percent in H.R. 3970, after you count in the 4-percent “surcharge” and denying extensions to the Bush tax cuts (regular increase in rates).
Plus you need to consider Senator Obama’s 15.3-percent SE tax proposal possibly applying to unlimited earned income.
That means federal tax rates can approach 59 percent. By the way, add state tax rates, sales taxes, and real estate taxes, and you are well over 70 percent.
If you earn money in a C-Corp, your top tax rate is 30.5 percent and you are often free of the SE tax, too.
But is it going to be 30.5 percent vs. 59 percent?
The Trojan horse is not extending the Bush tax cuts on “qualifying dividends” (currently taxed at 15 percent) and forcing taxpayers into double taxation. That’s 30.5 percent plus 59 percent.
Stay tuned!
December 19, 2007
AMT patch for 2007
Another annual “patch” for AMT in 2007.
As a short-term remedy (“extender” or “patch”), while big tax change proposals are being debated (which include AMT), Congress once again acted to temporarily fix AMT for the current tax year (2007); in the same way they have patched it for years’ past – with no new tax increases to pay for it.
One of the big problems with AMT is that by-law it’s not indexed for inflation; whereas regular income tax rates and most phase-ins and phase-outs (for deductions and credits) are indexed for inflation. This causes AMT creep (over regular tax rates) each year.
AMT became a huge problem for 2007, because AMT creep was heading towards AMT destruction; right before a Presidential-election year.
Whereas, only 4-million Americans paid AMT in 2006, 20-million Americans were expected to be snagged by AMT in 2007.
AMT generally comes up as a nasty last-minute surprise to taxpayers and it tends to make them angry. Neither Democrats nor Republicans want angry voters in a Presidential-election year.
AMT (inflation) creep has been fixed with simple patches (for inflation adjustments) in most prior years; and it’s also been done without much fanfare or a fight in Washington. Each year, this AMT patch is done earlier in the year, so the IRS has sufficient time to change tax forms in time for tax-filing season.
Too bad AMT caused great drama and tax-debate in 2007.
Perhaps, Democrats and Republicans wanted to showcase their differences in tax-values around the AMT annual tax fix.
With a Presidential-election year on the horizon, the new Democratic-controlled Congress took the opportunity to deploy their new “pay go” rules; to require new tax increases to pay for this annual AMT patch.
This was a fundamental change from prior years, where no new tax increases were required to pay for the AMT patch; which is really just a fix to put AMT on the same inflation index as regular tax rates.
Republican Congressman and President Bush were adamant about vetoing any new tax increase legislation in 2007. Hence we faced a ‘who blinks first game of chicken.’
The annual AMT patch-rite of passage was tied to the hip (“pay go rules”) by the Democratic-controlled House pushing to repeal “carried interest” tax rules for private equity and hedge fund managers.
Democratic Senator Chuck Schumer of NY (which includes important Wall Street constituents) did not like the carried interest tax increase selectively applying to investment-companies only (and not big oil and real estate too).
In the end, the Senate did not stand-firm with the House and this greater tax-debate was deferred until 2008; leaving plenty of time to debate the issues before the Presidential election.
In the end, the AMT patch was passed in the same way it’s always been passed; without any “pay go” tax increases.
But the Washington drama did taxpayers a great disservice.
By leaving the AMT patch open until December 19, 2007, millions of Americans could not finish their tax planning on time before the holiday break.
Congress can enjoy the holidays, but taxpayers and their accountants need to work through the holidays to deal with these (more important than ever) AMT changes. Again, that’s because AMT may be fully repealed in 2008.
The IRS has also said that tax refunds may be held up by at least 6-weeks because it’s too late to have AMT tax forms ready on time for tax-season.
Uncle Sam should change their name to Uncle Scrooge.
November 3, 2007
Year-end tax planning & the proposed repeal of AMT.
Year-end tax planning can be more challenging for traders than other taxpayers. Traders have widely fluctuating incomes and there are complex rules for wash sales, capital-loss restrictions, trader tax status and more. Plus, this year there are several proposed tax law changes to consider, particularly the potential repeal of AMT.
By Robert A. Green, CPA
Most year-end tax planning articles in the mainstream media focus on tried-and-true strategies, what I call “plain vanilla.” This Web site also features plain vanilla year-end tax planning at www.greencompany.com/Tools/Newsletters.shtml (November 2007 issue).
Active traders should also focus on tax-planning opportunities unique to their industry, especially traders rising to the level of business tax status.
Plain vanilla year-end tax planning strategies suggest that all taxpayers, including active traders, should generally defer income and accelerate expenses in order to reduce current year taxable income and tax liabilities.
But the AMT (Alternative Minimum Tax) is becoming an increasingly big problem that turns most tax planning logic upside-down. AMT is a huge concern for 2007, since it is snagging more taxpayers this year and because AMT may be repealed in 2008. Taxpayers therefore should make AMT planning job number one in overall year-end tax planning this year.
In the past, even plain vanilla planning dictated that if a taxpayer triggers AMT taxes, it’s usually better to defer non-AMT allowed deductions into the following tax year (like Q4 state taxes).
Plain vanilla planning tells investors to sell losing positions before year-end in order to reduce capital gains related taxes. It also suggests that wash sale loss deferrals are a bad thing.
Plain vanilla doesn’t cut it for active traders.
Active traders need better and more customized tax planning suggestions.
Here are a few nifty 2007 year-end tax planning tips for active traders. But first, a little more perspective on AMT.
AMT planning should dictate overall tax planning this year-end
If the Democratic-controlled Congress succeeds in repealing the AMT tax – which House Ways & Means Committee Chairman Rangel (D-NY) has issued a tax bill to do – most taxpayers should avoid paying any AMT taxes in 2007 (if at all possible).
Taxpayers may have the opportunity to permanently save AMT for 2007, since it may be repealed in 2008. Contrast this with prior years, were AMT taxes were often only deferred because AMT snagged the taxpayer in the following year (in increasing ways).
Chairman Rangel is also proposing to raise tax rates on upper-income taxpayers by increasing their top marginal tax rate to 44 percent from 35 percent. Chairman Rangel uses paying for AMT relief as the excuse.
By accelerating income into 2007 and deferring (AMT) tax deductions into 2008, a taxpayer can save taxes on two ways at once.
First, they can reduce AMT taxes for 2007 (hopefully permanently) and second, they can subject more income to 35-percent tax rates in 2007 rather than (possibly) 44-percent tax rates in 2008.
Unfortunately, the AMT tax credit will also probably be repealed along with the AMT tax. In prior years, if a taxpayer paid AMT tax, they had the opportunity for an AMT tax credit in a following tax year.
As a short-term remedy (“extender” or “patch”), while big tax change proposals are being debated (which include AMT), Congress has indicated it may seek to temporarily fix AMT by raising the AMT exemption amounts, so AMT affects fewer taxpayers. It is not clear if any such fix would apply to 2007. That should be clear by December.
AMT is unfair and it should be fixed
AMT was enacted decades ago to insure that upper-income taxpayers could no longer evade income taxes by using phony tax shelters and other tax schemes.
However, tax shelters were soon afterwards made illegal in their own right and Congress also enacted legislation disallowing tax losses from passive activities. Keeping AMT on the books after these other tax law changes made little sense.
Perhaps, Congress kept AMT as a stealthy way to raise taxes, while campaigning for elections on cutting or not raising regular tax rates.
AMT should have been indexed for inflation and that may have prevented the public uproar and problem now. AMT became ironic or even perverse in that it is attacking middle-class and less-rich taxpayers and not the super rich (the original targets of this tax).
AMT has also played a role in recent “red state vs. blue state” political standoffs. Blue state voters lose their higher state-tax deductions under AMT. Red state voters have lower state-tax rates (or none at all), so they receive preferential treatment under AMT.
Democrats won control of both houses of Congress partially because of the unpopular Iraq War. Democrats seem to be using fiscal (tax) policy, especially the unfair AMT and carried interest breaks, to also set and win the domestic policy debate.
With control of Congress and potentially the White House up for grabs in November 2008, the Democrats have set in motion a plan to roll back the Bush tax (rate) cuts, the Bush initiative to reduce taxes on portfolio and retirement income, and raise social security taxes, too. Plus, repeal AMT and provide new middle-class tax breaks.
Conversely, if Republicans win the White House, a more bi-partisan approach will probably take place on tax policy and Bush tax cuts will be defended.
Republicans have countered Democrats’ tax PR by saying they also want to repeal AMT, but they don’t want to offset that repeal with new taxes on upper-income taxpayers.
It seems likely that AMT will eventually be significantly reduced or repealed. So try your best to not pay AMT in 2007!
A few more notes about AMT and tax change legislation
For “married filing joint” incomes of close to $200,000, the regular tax rates are 28 percent, which matches the AMT tax rate.
That means these taxpayers will surely trigger AMT and be disenfranchised on many of their itemized deductions (state taxes, investment interest and expenses, miscellaneous deductions, portion of municipal bond interest and much more).
Futures and (electing) Forex traders also trigger AMT way too easily too. With 60/40 tax treatment on IRC 1256 contracts, their maximum tax rate is 23 percent – far below the AMT rate.
Thankfully, no current tax bill has threatened to repeal 60/40 tax breaks for futures traders. But note that in the Bush tax act of 2003, the Senate brought this repeal up as a point in negotiations. Thanks to last-minute lobbying from Chicago futures exchanges and the House standing firm, 60/40 tax breaks were safeguarded. If you strip away AMT, they may revisit this tax break too.
Most tax law change legislation discusses tax rates, and special deductions and credits. There are few changes discussed on business breaks, which include trader tax status and IRC 475 MTM, IRC 988 (Forex) or IRC 1256. That means active traders won’t have many changes to deal with, inside their industry.
One big change could be Fair Tax, a consumption tax to replace the income tax, but that won’t happen anytime soon with the Democrats controlling even one house of Congress.
Here is an example on how to avoid AMT
It’s best to prepare estimated income tax returns before year-end to see if you trigger AMT and for other tax-planning considerations discussed below.
Here is a good example: For regular income tax purposes, it’s smart to prepay all state income taxes before year-end, for an additional tax deduction and related reduction of tax.
But if you trigger AMT, prepaying some or all of your state income taxes is a big mistake, since state taxes are not deductible for AMT.
Instead, you can pay just enough fourth-quarter estimated state income taxes before year-end to equal the AMT threshold and pay the balance when due in the following year. That’s either Jan. 15 (for the estimated income tax safe harbor exception) or by the April 15 tax return or extension due date.
Traders have unique year-end tax planning opportunities and pitfalls
Again, the mainstream financial media often publicizes plain vanilla strategies for investors. But business traders sometimes should follow the reverse strategies.
First off, for the past decade or more, it’s no longer generally possible to initiate offsetting positions to defer capital gains on one leg of the position and realize (take) capital losses before year-end on the other leg of the position.
In the 1980s, Congress enacted IRC 1256 mark-to-market accounting (economic vs. cash accounting) for futures traders in order to prevent the above types of deferral abuse.
Congress and the IRS have also prevented this type of deferral abuse for securities traders by enacting special rules for wash-sale loss deferrals, straddle losses, constructive receipts, and selling positions against the box.
Qualifying securities business traders often elect IRC 475 mark-to-market accounting (for ordinary loss treatment rather than restricted capital losses), and this requires imputed sales for all open positions at year-end.
With MTM, traders do not have to sell open positions for tax loss selling at year-end. Rather, they can simply mark their open positions to market prices at year end.
Business traders use MTM on business positions only, not on segregated investment positions. Those they defer capital gains on until they have long-term capital gains tax rates.
Are wash sales always bad or can they be a good thing too?
Wash-sale loss deferrals are generally a bad thing, since they increase your capital-gains income in the current year.
But sometimes wash sales can be a good thing.
If a trader already has exceeded the $3,000 capital-loss limitation, it’s better to have wash sales rather than excess capital-loss carryovers.
The qualifying business trader will probably want to elect IRC 475 MTM in the following tax year, and their wash sales are converted to ordinary tax losses in that following year. They are part of the IRC 481a adjustment, which also includes year-end unrealized gains and losses (which are also preferable to carryover realized capital losses).
Conversely, capital-loss carryovers can never be converted into ordinary losses. A large capital-loss carryover may dissuade a trader from electing IRC 475 MTM; capital-loss carryovers can’t be applied against MTM ordinary trading gains.
Unutilized capital-loss carryovers are the biggest pitfall for traders.
Futures capital losses may be carried back three tax years, but only against futures capital gains.
Business “trader tax status” reduces AMT and unlocks significant other tax savings
With trader tax status and mark-to-market accounting (IRC 475), a trader can unlock all sorts of tax breaks, including business expenses, ordinary trading losses, NOL carry-back refunds, and retirement-plan and health-insurance (AGI) deductions.
IRC 475 MTM exempts traders from the onerous wash-sale rules and capital-loss limitations.
Trader tax status converts restricted investment interest and expenses (not deductible for AMT) into unrestricted business expenses (all deductible for AMT).
If an active trader doesn’t qualify for trader tax status in 2007, but expects to in 2008, they should consider deferring trading expenses until 2008.
Or, plan to capitalize 2007 “start-up” expenses (IRC 195) and amortize those costs when they achieve trader tax status in 2008. The first $5,000 of start-up costs may be expensed in the first business year, with the balance amortized on a straight-line basis over 15 years.
Some types of retirement plans need to be set up before year-end
Taxpayers need to establish a mini 401(k) plan (also called an individual or solo 401[k]) or defined-benefit (DB) plan before year-end; otherwise it’s too late to benefit. Full funding can wait until the tax extended due date.
Leading brokers offer excellent retirement plan packages.
Mini 401(k) plans are among the best retirement plans for traders.
Taxpayers can contribute the elective deferral maximum ($15,000 for 2007), plus there is a 20-percent net profit-sharing plan included, too.
With a mini 401(k) plan, a taxpayer can enjoy maximum income tax savings in exchange for self-employment (SE) tax costs. Structured in the right manner, the active trader usually saves more in income taxes than they pay in SE taxes.
A mini 401(k) plan requires an annual 5500 or 5500-EZ filing.
With a DB plan, higher-income traders can contribute much higher amounts than the limit on defined contribution or profit-sharing plans (including the Mini 401[k] plan).
Note that trading gains are not earned income, unless a trader is a member of an options or futures exchange. So, non-exchange traders often need to form entities to create earned income for retirement-plan deductions, unless they have another source of earned income
Consult a trader tax expert on these strategies.
A Roth IRA conversion may be a good strategy, too
Because traders have fluctuating income from year-to-year, they may fall under the Roth IRA income threshold in 2007. That can be a good time to do a Roth IRA conversion.
Pay taxes at 2007 tax rates on the conversion amounts, before tax rates possibly go up, and then trade the account (permanently) tax-free through retirement.
Permanently tax-free means a taxpayer can take distributions in retirement tax-free, too.
If you exceed the income thresholds, build up a regular retirement plan and consider a special break currently on the books for 2010 only. The Bush Tax Cuts relaxed the income threshold for all taxpayers in 2010 only in connection with Roth IRA conversions.
You can also consider a mini Roth IRA.
Try to qualify for “middle-class tax breaks”
Almost every middle-class tax break, including deductions and credits (such as retirement, education, and child care), have preset phase-ins and phase-outs based on varying levels of Adjusted Gross Income (AGI).
Democrats plan even more tax breaks for the middle class along these lines.
Active traders can qualify for these breaks in some years and not in other years (when they make their bigger gains).
Only good tax planning and preparation software can figure it all out in your favor and on time before year-end.
Our progressive tax code was historically based on progressive income tax rates (graduated marginal tax rates), and now tax writers are using complex specialized income formulas to control access to other tax breaks, too.
Fine tune your year-end tax planning to get into the right tax bracket with the right formula for maximum savings.
Bottom line
Prepare a proforma year-end tax return using 2007 tax software. If you trigger AMT, try to figure a way to prevent AMT. Assess your trader tax status and capital gains and losses year-to-date along with all unrealized gains and losses on open positions. Develop the right strategy to reduce capital gains and maximize the $3,000 capital loss limitation – but don’t exceed that capital-loss limitation amount if possible. Develop the right tax strategy for 2008 to complement your 2007 tax planning and save even more in 2008. It’s probably best to engage a trader tax expert for more help.
August 26, 2007
How to deduct a loss on the sale of your home, avoid debt extinguishment income in foreclosure and deal with abusive mortgages
Traders and others should start focusing on tax and legal planning in connection with declining real estate values and (predatory) mortgages.
Learn how to convert non-deductible losses on the sale of your home into ordinary loss tax deductions.
If you face foreclosure, learn how to avoid phantom taxable income on debt extinguishment by claiming insolvency.
Finally, did your bank or mortgage broker sell you a fraudulent mortgage that was the worst available product and can you get it fixed, without incurring too much pain? Read the NY Times Sunday 8/26/07 expose article on the (predatory) unsavory sales practices at Countrywide (the largest mortgage broker). Countrywide promised the “best” mortgage product, but highly compensated their brokers to instead sell customers the “worst” mortgage product. Isn’t that fraud?
Convert non-deductible home sale losses into ordinary and capital losses
There is a nasty flipside to the tax-beneficial rules of owning your principal residence. Yes, the capital gains are tax-free until you exceed the home sale exemption amounts: $250,000 for single status and $500,000 for married filing joint status.
But tax losses on the sale of your home are not allowed! Few taxpayers realize this unfortunate tax fact until it’s far too late.
If your real estate is not your principal residence, it can be deemed an "investment property" and normal capital gains and loss rules apply. But then the dreaded capital-loss limitation of $3,000 comes into play. Add stock losses with declining markets to the mix and you are again stuck with unutilized losses.
We saw a huge housing price correction before, in the late 1980s and early 1990s. Here's a nifty tax planning strategy that worked well then and should work great again now in this correction:
Rather than incur a non-deductible loss on the sale of your principal residence, convert your home to a rental property first (a short period of time can work) and then incur an (allowable) ordinary tax loss on Form 4797.
There are some nuances to this tax strategy, so check with an expert (such as our firm). When you convert your property to a rental property (income-producing use), you are supposed to use the lower of cost or fair market value (FMV). But FMV on an illiquid and unique home is not readably available, so there is some leeway here.
Avoid phantom income taxation in foreclosure
If you can't pay your mortgage and you suffer home foreclosure, understand that you will be given a Form 1099 for debt extinguishment income from your lender. That's taxable income on your tax return.
But there is a way out of this income. If you are financially insolvent (negative net worth) at the time of debt extinguishment, you don't have to report that phantom income. Many who face foreclosure are probably insolvent.
Demand that your broker and bank fix your mortgage
After you read the NY Times article on the alleged wide-scale abusive sales practices of Countrywide, you should examine your own mortgage loan terms carefully and consider engaging an attorney to help you. I am guessing these types of abusive lending practices are more widespread and not unique to any one mortgage broker.
Don’t think the term “predatory” only applies to sub-prime mortgages for lower income people. Reports of wide-scale lending excesses based on poor credit and highly risky loan terms (zero down payments) seem to support the position that abusive mortgage sales practices were used by many providers across the board, especially if the underlying loans could be repackaged as mortgage-backed securities and sold to unsuspecting investors. This process took the cooperation of several (knowing and perhaps conspiring) banks and brokers.
In my initial view, many mortgage holders can probably engage an expert to review their mortgage terms to hunt for conflicts of interest, compensation tied to selling them the inappropriate terms and other abuses.
These types of abusive lending practices seem very worthy of wide-scale legal attack by consumers and regulators (who are charged with protecting consumers). Maybe it’s not on the scale of asbestos and tobacco, but it’s still very important to millions of families. Fraudulent lending practices may not kill you from a health standpoint, but over-burdening fraudulent mortgages are destroying many people’s finances, which can go on to ruin families and health. Will families have to cancel health insurance to pay for fraudulent mortgage interest-rate hikes and endless fees?
I don’t think everyone should just pay for these abusively generated mortgages without a fight first. Will judges award home deeds to (perhaps fraudulent) abusive mortgage holders in light of this fiasco? I imagine that several law firms will start class-action lawsuits against these mortgage brokers and banks soon to get to the bottom of these abusive lending actions. Many mortgage brokers that have not already succumbed to market changes will go out of business to avoid this onslaught. In my view, this is Enron-like, only on a much bigger and wider scale.
If attorneys do attack mortgage brokers, don’t you think it’s “catching a falling knife” to buy mortgage lenders’ stocks now? Don’t misinterpret recent investment and loan support from larger banks to distressed mortgage brokers; that may be an effort to constrain legal attacks away from their own borders. Again, the mortgage brokers cooperated closely with other banks to package and sell these mortgage-backed securities based on carefully constructed excess (rather than reduced) risk. Isn't that a conflict of interest, too? Shouldn't the cooperating banks try to assemble lower-risk securities, rather than building excess risk? If the securities fail, shouldn't the seller of the securities be liable for the losses if they built in excess risk on purpose and did not disclose it (just to get more fees for themselves)?
This mortgage meltdown story is getting bigger, not smaller, in my view. I fully support the Federal Reserve Bank for adding liquidity and lowering the discount rate. In my view, that is putting out financial market fires (that can burn everyone), and that’s not a moral hazard. But it will be a moral hazard for regulators to interfere with (coming) legal attacks on mortgage brokers and banks that participated in these alleged abusive sales and business practices.
Here’s the bottom line:
If you have a brewing loss on a recently purchased home, consider converting it to a rental property, so you can deduct your loss for tax purposes. If you can’t pay your mortgage and you get foreclosed, don’t get hit with a tax bill on that phantom income by reporting insolvency. If you think you were subjected to abusive lending practices and you face high adjustable interest-rate hikes plus fees, seek legal help before proceeding.
Feel free to contact our firm for help. We can help plan and execute the above tax strategies. We can also refer you to legal counsel, although we don't know any law firms that have taken on this challenge yet.
Robert A. Green, CPA & CEO