By Tony Cardinalli, CPA
The Dow Jones Industrial Average has seen 20% of its value decline in 2002. Many investors were avoiding the dreaded phone call to their brokers instructing them to sell off their positions before things got worse. Their losses were causing them to lose sleep at night. It happened. They called. An original tax strategy herein will provide some additional damage control.
Countless taxpayers will carry forward those stock market losses into the future because of the $3,000 limitation rule. This limit puts a floor on the allowable losses at a negative $3,000. But, capital losses are allowed to the full extent of capital gains. This article suggests a tax planning strategy that could eliminate the carry forward of those stock market losses. If the taxpayer has other appreciated capital assets a deemed sale may be used to free up those losses.
The Feds first made the election available in 2001. Most accountants were unsure of its potential and were relying on the rule of thumb that one should always defer the payment of taxes as long as possible. Although, an astute tax preparer would have noticed that the real estate investment managers were electing the deemed sale and pushing them through on their investors K1's and 1099s. Well, another year of losses is here and mainstream taxpayers will be looking for ways to free up two years of capital losses. It is time for the individual investor to take a cue from corporate America.
The deemed sale election still only makes sense when taxes are not prepaid. In other words, that rule of thumb mentioned earlier still applies. That said, when the taxpayer has substantially appreciated capital assets (such as a rental unit) and has suffered capital losses (from the stock market decline), she can wash the gain on the former against the loss on the latter and end up with a zero or minimal capital gain. Note, a personal residence is qualified property, but the exclusion on the sale of a personal residence is abated if the deemed sale election is made.
To carry the example out further, after assessing the amount of capital losses that have been incurred in the stock market, the taxpayer would appraise his real estate asset and determine the amount of gain that would be recognized. An appraisal would be made on the real estate property and the difference between the appraised value and the cost basis of the property would be the deemed gain. The two amounts should be compared, and if the combined total results in a gain, it is taxed at the favorable 18% gain rates. A loss situation would have to be carried-forward into future years.
Now, the clock has started on the deemed-sale property and a new basis has been established. Advantage is to the taxpayer here because she will take advantage of additional depreciation. Furthermore, if the property is held for five years and then sold, any gain will be determined based on the stepped-up basis and taxed at the 18% gain rates. But ultimately, at the end of the day, this strategy employs those capital losses to do something other than sit on a carry-forward schedule until this market turns up again. In tough times, the investor has to get tougher. Now is not the time for wimps to snivel about their losses, but for winners to go out and make lemonade.
Tony Cardinalli is a CPA in San Francisco. He provides bookkeeping through tax return preparation and computer consulting to small and medium sized businesses. His phone number is 415-665-8000.