Understanding the Wash Sale Rule and Capital Loss Harvesting

Typical year-end tax planning involves the “harvesting” of tax losses.  The word “harvesting” means selling investments with unrealized losses in order to trigger tax deductions.  Taxpayers who allocate their investments across different asset classes will nearly always have some investments that lose money.  That is the nature of diversification.  Selling securities with losses will produce capital losses for income tax purposes.  These losses can offset capital gains and up to $3,000 of ordinary income.  Capital gain taxes can be surprisingly high given the layers of taxes imposed.  See the tax rates shown in the table below.

Prudent investors will want to repurchase securities to maintain their asset allocation percentages.  The “wash sale” rule is a tax rule that disallows the deduction of realized capital losses in certain circumstances.  The rule applies if the repurchased security is substantially identical to the security that was sold, and the repurchase occurs during the 61-day period starting 30 days before the date of sale and ending 30 days after the date of sale.  In other words, in order to deduct the capital loss, the government wants you out of the investment for at least 31 days before repurchasing the same security.  The date to be used is the “trade” date rather than the “settlement” date.  The loss disallowed under the wash sale rule is added to the cost of the replacement security.  So the loss isn’t permanently disallowed, it is just deferred until the replacement security is sold.

In order to trigger the tax loss but remain invested in the asset class, the replacement security needs to be a different security.  For example, you could purchase stock in another company in the same industry, or purchase a mutual fund from another fund family.

The wash sale rule also applies to related accounts and spouses.  The rule will apply if you use your IRA to purchase a substantially identical security to the one sold in your taxable account.  A husband cannot purchase the same security sold by a wife within the 61-day period and avoid the wash sale rule.

Capital Losses Can Save Taxes at These Rates	Top Federal Rate	Obamacare Rate	Itemized Deduct Phaseout	Utah Rate	Total  Tax Rate
Short-term capital gain	39.6%	3.8%	1.2%	5.0%	49.6%
Long-term capital gain	20.0%	3.8%	1.2%	5.0%	30.0%
Real estate recapture CG	25.0%	3.8%	1.2%	5.0%	35.0%
Collectibles capital gain	28.0%	3.8%	1.2%	5.0%	38.0%

Last Minute 2013 Personal Tax Planning

Consider implementing the following strategies by December 31^st to save income taxes.  The income tax laws are now so complex that it is difficult to know whether any of these general recommendations will actually save you tax without undertaking a computerized tax projection.  You should consult your tax advisor before implementing these ideas.

1.      Harvest capital losses as necessary to reduce capital gains tax, and to lower the Obamacare tax on net investment income.  Be sure to avoid the “wash sale” rule that applies if you purchase substantially identical replacement securities within 30 days before or 30 days after the date of sale.

2.      Be sure that any year-end charitable donations are either delivered or mailed and postmarked by the 31^st.

3.      For those at least age 70 ½, consider using your traditional IRA to make a direct charitable donation.  This can satisfy your 2013 minimum required distribution and lower your overall income tax.

4.      Consider donating any long-term appreciated securities to charity.  You can claim a tax deduction equal to the fair market value without triggering tax on the capital gain.

5.      For those at least age 70 ½, and for those who have inherited an IRA, don’t forget to take your minimum required distribution by the 31^st in order to avoid a 50% penalty.

6.      Prepay state income tax unless you are subject to the alternative minimum tax (AMT) because taxes are not deductible for the AMT.

7.      Consider accelerating ordinary income into 2013 if you are subject to the AMT and may not be in 2014.

8.      Consider making a Roth IRA conversion if you are in a lower tax bracket this year.

9.      For purposes of gift and estate tax planning, don’t forget to use the $14,000 annual exclusion.  Giving cashier checks is advisable when cash gifts are made at year end to be sure that the gift is completed in the 2013 calendar year.

10.  Many upper-income individuals will suffer dramatic 2013 tax increases from the combination of income tax rate hikes and the start of Obamacare taxes.  Such taxpayers should consider estimating these tax increases in order to avoid surprises at April 15^th and to be sure sufficient cash is on hand to pay the additional tax on time, in order to avoid late payment penalties and interest.

Last Minute 2013 Business Tax Planning

Although, the IRS has delayed the start of tax filing season to January 31, 2014, taxpayers have less than two weeks until December 31, 2013, to implement any “last minute” income tax planning strategies.  Here is a checklist of several strategies applicable to businesses:

1.      Purchase and “place in service” any necessary equipment or furnishings by December 31^st to take advantage of  the 50% bonus depreciation that goes away after 2013 and to utilize the higher Section 179 business expensing limit of up to $500,000 that drops to only $25,000 for tax years beginning in 2014.

2.      Adopt a qualified retirement plan, such as a profit sharing plan, a 401(k) plan, or a defined benefit plan.  Unlike a qualified plan, a simplified employee pension (SEP) plan does not need to be adopted by December 31^st.

3.      Purchase stock directly from a qualified small business C corporation to be eligible for a potential 100% gain exclusion upon a future qualifying sale of the stock.  The exclusion drops to 50% for stock purchased after 2013.

4.      Cash basis taxpayers should pay and mail all outstanding bills and payroll by December 31^st.

5.      Accrual basis corporations may declare and accrue bonuses by December 31^st as long as actual payment occurs no later than March 15, 2014.  Special rules exist for shareholders owning directly or indirectly more than 50% of the corporation’s stock.  Bonuses to such shareholder-employees must be paid by December 31^st to be deductible.

6.      Estimate the business’ marginal income tax rate for 2013 and 2014 and shift income and deductions as appropriate to allow more income to be taxed at lower tax rates, or to allow more deductions to be claimed at higher tax rates.

7.      If you own an interest in a partnership or an S corporation, you may need to increase your tax basis in the entity so you can deduct a loss from it for this year.

 

Written Capitalization Policy Statement Required by December 31, 2013!

The Federal government recently published final regulations concerning the acquisition, production, and improvement of tangible property.  The regulations are effective for tax years beginning on or after January 1, 2014.  These regulations have been in the works for about 10 years and will change how businesses have historically accounted for repairs, maintenance, and asset purchases.  One of the provisions requires prompt action by all businesses.  This blog post is limited to this provision.  Future posts will cover other aspects of the final regulations.

The regulations provide for an annual "de minimis" safe harbor election for expensing the cost of tangible property equal to or less than a certain threshold amount.  The threshold amount is $5,000 for businesses that file financial statements with the SEC or with a state or local government, or that have a certified audited financial statement (reviewed or complied statements don't qualify).  These financial statements are termed, "applicable financial statements." The threshold is only $500 for businesses without applicable financial statements.  The safe harbor expensing election also applies to tangible property having an economic useful life of 12 months or less.  Note that this de minimis safe harbor election is different from, and is in addition to, bonus depreciation, and expensing under Section 179.

The safe harbor election requires that the business have a written capitalization policy for their financial accounting records BEFORE the start of the tax year for which the expensing will be taken.  Be sure that you have a written policy in place by December 31, 2013 if your tax year starts January 1, 2014.  Without a timely written policy, you can't elect the safe harbor, and asset purchases you choose to expense will be subject to challenge by the IRS, even if under the threshold amount.  The capitalization policy should refer to the dollar threshold amount, and also state whether property having an economic useful life of 12 months or less is also required to be expensed.

In brief, the requirements of the safe harbor election are as follows:

• A written capitalization policy statement is in place before the start of the tax year,
• The purchased items are actually expensed in the financial statements,
• The invoice total, or the cost of each asset purchased as itemized on the invoice, is equal to or less than $5,000 or $500 as applicable, and
• An election statement is made on a timely filed, original income tax return for each tax year.

The expensing ceiling is an all or nothing approach.  For example, if an item cost $5,001 (or $501 if no applicable financial statement), none of its cost can be expensed.