Year-End Tax Traps For Investors

As year end approaches, investors should be aware of two potential tax traps that could affect their 2007 federal tax bills.

Watch Your Capital Gains and Losses
With the stock market’s dramatic ups and downs this year, many investors have been left with a mix of unrealized capital gains and losses on their investments. Ignoring the unrealized gains and losses in your portfolio could result in your paying more taxes than you need to, especially if you realized gains and losses on investment sales earlier in the year.

First, some background: In general, capital gains on assets that you have held for more than one year are treated as long-term gains, subject to a maximum 15% capital gains tax rate. Some long-term gains (on collectibles, for example) are taxed at higher rates. Short-term capital gains — gains on assets held one year or less — are taxed as ordinary income.

Capital losses typically offset capital gains (long- and short-term) dollar-for-dollar. Plus, excess capital losses over capital gains reduce ordinary income (taxable at up to a 35% federal rate) by up to $3,000 in losses ($1,500 for married taxpayers filing separately). (Note that the rules are complex and professional guidance is essential, especially if you have combinations of short-term gains and losses and long-term gains and losses, or gains or losses on real estate, art, or other collectibles.)

Now take, for example, a 35%-bracket taxpayer (we’ll call him Lou) who, earlier this year, realized long-term capital gains of $25,000 on stocks he sold. As year end approaches, Lou is sitting on investments with unrealized short-term capital gains of $30,000 and unrealized capital losses of $28,000. Lou has several options from a tax perspective, including:

• Offset the gains. Lou could sell some of the investments on which he has unrealized losses and offset the $25,000 of capital gains on the investments he sold earlier in the year. By doing so, Lou could avoid paying some or all of the capital gains tax on those earlier gains.
• Offset ordinary income. Lou could instead sell all of the investments on which he has losses and not only offset his earlier gains, but also offset $3,000 of his ordinary income.
• Delay the sale and pay the tax. Since Lou’s earlier gains were of the favorable long-term variety, Lou may want to hold off on selling his losers until next year. This would allow Lou to take advantage of the relatively low long-term capital gains rate in 2007, while using his unrealized losses to offset any later gains (perhaps those short-term gains) on other investments he holds. (And, who knows, maybe some of those current losers will end up in the winner’s circle, given some time.)

On the other hand, if Lou had realized capital losses earlier in the year, he might want to look at selling a few of his winners and using the earlier losses to offset his gains.

While tax considerations are only one factor to weigh when deciding to sell an investment, careful tax planning can help you make the most of your capital gains and losses. It is easy to make a misstep in this area, resulting in lost tax-savings opportunities.

Be Aware of Year-end Fund Distributions
During late November and December, many mutual funds make distributions to shareholders. Some commentators believe that fund distributions for 2007 may be especially large, since many funds locked in large gains earlier in 2007 and some funds no longer have on their books large losses from the early 2000s, which they used to offset their gains in recent years. Many international funds have had significant gains, together with a high rate of turnover of investments. Some funds have forecast distributions of 10% or more of fund assets.

These distributions can result in a tax pitfall for unsuspecting investors. By investing in a fund right before a distribution, you may be buying an additional immediate tax liability. Any taxable distribution for 2007 will generally have to be reported by you on your 2007 tax return, even if you held the fund for only a few weeks or days. You, in effect, will have a potential tax liability for the part of the purchase price of the fund you get back in the form of the distribution.

Therefore, it is a wise move to do your research before buying a fund (or adding more money to an existing position) before year-end. Fund information, such as the distribution payment date and the potential capital gains exposure, is available — usually on the fund’s website or through one of the mutual fund research services.

If you need guidance about the tax impact of your investments — or any other tax matter — talk to us. We stand ready to review your specific situation with you and help you develop a strategy that meets your needs. Contact us today.

The information provided in the newsletter has been obtained from sources believed to be reliable but its accuracy is not guaranteed.