Running big paper loss? A switch could cut taxes
Suppose you own long-term bonds, shares in a bond mutual fund, or income stocks with a substantial capital loss. Should you switch out of those investments and buy something else, using the long-term loss to reduce taxes? Such a maneuver is worth considering.
Investor A, now aged 70, retired in 1978 and invested $50,000 in a good-quality bond fund with the objective of gaining current income to supplement his other retirement income. Now the value of the shares has fallen 25 percent, to about $37,000. Return on the depreciated value of $37,000 is about 12.8 percent, but on the original investment it's only 9.5 percent. Question: Should he sell the shares, use the $13,000 capital loss to reduce 1981 income taxes, and reinvest the proceeds in shares of a different income-oriented fund (to avoid the wash-sale rule) with a better return?
Many investors considered the 9.5 percent return available on bonds, mutual funds, and income stocks to be a highly desirable income yield in 1978. Since then higher interest rates have discounted prices of bonds and income stocks. Reader A could hang onto his bond fund shares with the expectation that if and when general interest rates subside, the shares will regain their original value. But taking the loss may provide a profitable alternative.
Using the figures from Reader A's letter, the $13,000 would be available as a long-term capital loss for 1981 if sold before the end of 1981. Losses to reduce income taxes are worth more in 1981 than they will be in 1982 and '83. Since long-term losses may be used to offset long-term gains or as much as $3,000 of ordinary income on a 2-for-1 basis, part of the loss might be carried over to 1982 and '83. With no offsetting capital gains, the $13,000 long-term capital loss would offset $6,500 of ordinary income - but only $3,000 during 1981. If Reader A's marginal tax bracket is 36 percent, he would reduce his taxes by $1, 080 in 1981 and another $1,080 in 1982, plus $180 in 1983. Capital losses may be carried forward for as many years as necessary to use them up.
Using Reader A's figures, his bond fund shares are now earning $4,736 a year in taxable income. Reinvesting the $37,000 in a similar fund would likely return about the same annual income. The cost basis of the fund shares would now be $37 ,000, however, assuming no cost for a no-load mutual fund. Later, if and when interest rates decline, the capital value of the shares may again reach the original $50,000. If the shares should then be sold, the $13,000 would represent a long-term capital gain if they were held for one year or longer. Income taxes on the long-term capital gain would be 36 percent on 40 percent of the gain. Thus, 40 percent of $13,000 figures to be $5,200, and 36 percent of that figure would be $1,872 in taxes. If the increased value were included in Reader A's estate, little or no tax would be due under the higher exemptions provided in the new tax bill, beginning with $225,000 for 1982.
Thus, this reader would gain in taxes by $468. Total deductions over two-plus years would be $2,340, less the $1,872 paid if shares were sold. Under these conditions, Reader A would lose little or no current income; and he'd gain an immediate tax deduction for the loss and possibly incur a future tax liability (somewhat less than the tax deduction).
If your situation is similar and your marginal tax bracket differs from the 36-percent figure assumed, benefits (if any) would also differ. You should consult your tax adviser before proceeding.Gifts to avoid taxesA previous ''Moneywise'' column noted that ''you can give an interest in the land to your nephews at the rate of $3,000 per year to each.'' Does this mean that I may give actual title to land to my three sons? I have Florida property worth about $200, 000 and pay a minimum of taxes. How do I do it? -- G. G.
Since the first ''Moneywise'' answer appeared, the new federal tax laws may simplify your wish to convey title in the Florida land to your children and pay little or no taxes. Beginning in 1982, the exemption from federal estate taxes increases from $175,625 to $225,000, and the amount increases yearly until it reaches $600,000. Thus, depending on how much other property might fall into your estate, you would not need to give a series of partial titles in the land to your children to avoid federal taxes. Also, beginning in 1982, the federal tax-free gift exclusion increases from $3,000 to $10,000 per donee per year. You will need to check on the exclusion for both gifts and estates or inheritances in the state where you live and also in Florida. If state inheritance taxes remain a problem, you might wish to set up a trust whereby your children acquire an interest in the land each year without incurring a gift-tax liability. You will need a lawyer to draft the document. Very likely the exemptions and tax rates on gifts and estates or inheritances at the state level will be raised or eliminated to agree or come close to the federal gift and estate tax changes within the next few years.Older exemptions avoid taxA previous ''Moneywise'' column advised a widow, 70, to invest in utility stock producing 15 percent income. Then, it said that most of the income would be tax free. Can you explain how? -- L. L.
The specific answer referred to a woman who had only a minimal income from social security and about $30,000 in assets. Investing for current income would generate about $4,500 yearly, ''most of which would be tax free.'' This phrase referred to her low income, which, with her two exemptions, would leave her liable for only a small income tax. The 15 percent return available to her at the time of the previous column is no longer available, as the prices for utility stocks have risen and yields have fallen. Depending on which utility she may have bought, a portion of the dividends may be tax free as a return of capital. The payment of dividends from retained earnings, a form of capital, is sporadic and is difficult to anticipate. The reference to tax-free income in answering the widow was meant to indicate that her taxes would be minimal.