With the April 15 deadline for filing federal income tax looming, as an investor you need to take some time now to ensure that you are handling your taxes strategically and preparing yourself for a secure future.
No tip is more important than the dedicated act of organization all year long so that tax season can be a routine exercise, not a period of stress and frantic searching. Even if you have a financial planner handling your investments or you hire a Certified Public Accountant, they can only assist you to the degree that you provide them with thorough and accurate information.
The days of shoving everything into a shoebox and showing up in the rush period of tax season hopeful that a virtual stranger can create order in your affairs and take full advantage of all tax savings for you is bordering on the ridiculous. Tax strategy is a 12-month exercise.
However, there are a number of portfolio checks you can consider this time of the year to ensure that you maximize your tax savings.
Owning rental properties
One source of investing that has sizeable tax advantages in the United States is rental property. An investment in a $100,000 rental home, for example, means that you can depreciate the structure of the home over 27.5 years.
You cannot depreciate the land basis, but you can still save a lot. For example, if the lot is valued at $10,000 and the house itself is valued at $90,000, each year you can claim a tax deduction of $3,272.73. Simply calculate the house value divided to 27.5 years to see how this would apply to you.
When you further deduct your expenses and maintenance of the house, and then calculate your rental income, you still may end up not having to pay a penny on this asset.
And even if the house and property increase in value substantially throughout the years, you still don’t have to pay tax on the appreciation until you decide to sell it. It can amount to a substantial saving.
When you do decide to sell that property, if you do a 1031 exchange, which means to move your profits into a new property purchase, you may again escape taxation.
The 1031 Exchange
The United States Internal Revenue Code Section 1031, often referred to as the tax deferred exchange, is a tax strategy that allows you to sell one qualified property and purchase another qualified property within a specific time frame and save taxes in the process. In essence, the IRS is allowing you to classify this transaction as an exchange, not a sale, and you do not have to pay taxes on the profits you gain from the sale of the first property.
If you decide to engage in this strategy, be sure that you are familiar with all the rules and caveats of the Section 1031 or have an adviser who can assure you that you qualify.
Basically, however, if you plan to replace one kind of real estate with a similar kind of real estate, you should consider this.
Asset Placement
Another effective tax strategy, asset placement, involves re-examining your investment portfolio to check whether or not some of your investments which produce ordinary income could produce better inside a tax-deferred plan. It also considers whether or not investments that produce long-term returns might produce more favorable tax results if they were in taxable accounts.
You may sometimes find yourself surprised that a person with a portfolio similar to yours is actually paying less tax. That is when you realize that where you are holding your investments can be just as important as what you are holding.
The bottom line you need to be watching when you examine asset placement is what you earn on your capital when you factor in the compound annual after-tax, inflation-adjusted return.
When you are not diligent about this, and you end up overpaying taxes because of it, you are essentially cheating yourself twice. You lose the money to the IRS initially and then you lose your ability to take that money and re-invest it to earn more profit.
It is a good idea as tax season approaches to sit with your financial advisor and find out more about the different tax treatments your different investments receive based on where they are held.
As an example, you will pay less tax on income you receive from capital gains than you will on income received from bond interest and dividends.
As a general rule, if you have high-yielding common stocks that have consistent dividend payouts, risk arbitrage transactions, corporate bonds and shares of real estate investment trusts (REITs), they should all be placed in such tax-advantaged accounts as the 401k or the IRA.
If you have common stocks that you expect to hold for more than a year and which have no dividend payouts, or very little, you should keep them in regular, non-tax advantage accounts. The same can be said for tax-free municipal bonds.
Check out your passive income
For the investor, the ultimate prize is passive income, that money that just keeps on coming without a fresh infusion of labor or cash.
During tax season make sure that you are getting to keep the money that is coming in.
For example, if you invest in a tax-free municipal bond, you can escape taxation entirely, but if you purchase a traditional corporate bond, you could be paying as much as 41 percent of your passive income back to the IRS.
It is important to always figure out your actual, after-tax income each year. You may be able to keep more of your money just by shifting the types of holdings you have.
Revisit your portfolio yearly
When it comes to effective tax strategies, include setting aside time each year in the non-tax season to review your entire portfolio. Some people link their review to a specific event in the year, the week after their birthday for example. It doesn’t matter so much when as that you book it and do it.
Go through every single one of your investments, analyze them, and ensure that they are still growing, that they are still safe, that they are diversified and that they yield good after-tax results.
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