Investments 46) The biggest mistake made by stock market and mutual fund investors is not to "earmark" the shares sold. When shares are purchased over a period of time, they are purchased at different prices. At the time some shares are sold, you can control which shares are considered to have been sold. The choice will not affect the amount of money received on the sale, since the shares are all being sold at the same price. But it can affect your tax bill, and thus the amount of money you end up with. Suppose you bought 10 shares at $10 each and later bought 10 more shares at $15 each. Now the stock is at $20 and you want to sell 10 shares. If you write your broker a letter stating that the second 10 shares are to be sold, your gain will be $5 per share. But if you do not designate which shares are sold, the IRS will treat it as though the first shares purchased were the first ones sold. So your gain will be $10 per share. This makes a sizable difference in your tax burden. Mutual fund shares also can be earmarked in writing when they are sold. But the results are a little different if you do not earmark the shares. Instead of the first-in, first-out method, you use an averaging method to determine the basis of your shares. You add up the cash you've invested plus dividend reinvestments, and divide that by the number of shares you owned before the sale. The result is the basis for each share sold. By using this method, you lose the ability to influence the amount of your gain or loss for tax purposes. 47) You can earn interest and dividends tax free. Many taxpayers with high investment income can control whether or not they pay taxes on that income. One of the few interest deductions left after 1990 is the deduction for investment interest expense to the extent of net investment income. Suppose you have investment income, such as interest and dividends, of $10,000 for the year. This is included in Schedule B and added to your gross income. If you itemize deductions and paid $10,000 of investment interest, the investment interest expense deduction offsets the investment income. This means that if you can generate investment interest expenses, you can shelter the investment income from taxation. The deduction for investment interest also is not subject to the new itemized deduction reduction. Any investment expense that you cannot deduct because the interest expense for the year exceeds net investment income can be carried forward to future years. Net investment income is investment income minus directly connected noninterest expenses, such as investment counsel fees, accounting expenses, insurance, subscriptions, and legal expenses. Investment income includes interest, dividends, royalties, rents from net lease property, and amounts recaptured as ordinary income. Investment interest includes interest incurred to purchase or carry investment property, other than tax exempt bonds and insurance policies. Margin account interest is the usual source of investment interest expenses. Interest on rental properties that qualify as passive activities does not count as investment interest. But in most cases interest on debt incurred to purchase undeveloped real estate counts as investment interest and shields investment income. Another approach: Instead of buying a consumer item such as a car with debt and purchasing stocks for full price, pay cash for the car and buy the stocks on margin. You should consider factors other than taxes, but when only taxes are considered you come out ahead with this strategy. Capital gains used to be included in net investment income. But the 1993 tax law eliminated that in most cases. You can, however, elect to include capital gains in your net investment income if you agree that your net long term capital gains will be taxed at your regular income tax rate instead of having a 28% cap. This can be an advantage if your regular tax bracket is 28% or 31% anyway. It can also be an advantage if your investment interest is high enough to shelter most of the capital gains from tax. Remember that any unused investment expense can be carried forward to future years. So if you expect a lot of interest and dividend income in the future, it might be better to take the 28% rate against your capital gains and let the investment interest expense carry forward to shelter the other investment income. 48) Upgrade your insurance policy and get favored tax treatment. New insurance policies provide investment and tax benefits that are far superior to older whole life insurance policies. Some policyholders are afraid that if they cash in their old policies they will have to pay taxes on the accumulated earnings of the cash value. That's not true. The tax code allows you to exchange insurance policies tax free. You can exchange life insurance for life insurance, an endowment contract for another endowment or annuity contract, and an annuity for another annuity. All these exchanges are tax free whether or not the policies are with the same company. Many insurance companies have programs that allow you to trade in the policy of a different insurer when you take out a new policy. A recent Tax Court case makes the exchange even easier. The taxpayer's old insurer refused to transfer the cash value of her old annuity to the new insurance company selected by the taxpayer. Instead, the old insurer issued a check to the taxpayer, and the check was immediately reinvested in the new annuity. The IRS claimed that there was income when the check was received because the taxpayer was not bound to reinvest it. The Tax Court disagreed. It said that the tax-free exchange provision is to be broadly interpreted. You can cash in your old policy and use the proceeds to buy a new policy immediately. (Green, 85 TC No. 59 (1985). The IRS ruled that the tax-free exchange of insurance policies applies when you exchange an U.S. annuity for a foreign annuity. There is no requirement that either or both of the insurance policies exchange be issued by insurers doing business in the United States (Letter Ruling 9319024). 49) Not all foreign accounts have to be reported to the IRS. When your foreign bank accounts do not exceed $10,000 at any time during the year, you do not have to report them. In addition, a reportable account is any foreign financial account over which you have signatory authority. A bank account and a brokerage account are considered reportable accounts. But the Swiss GoldPlan account has been designed so that it is a precious metals purchase-and-storage account that does not have to be reported. You can protect your privacy by purchasing and storing gold abroad. SwissPlus is a very flexible annuity that is both tax-deferred and non-reportable, and cannot be seized by creditors. (Information on both GoldPlan and SwissPlus can be obtained from JML Investment Counsellors, Dept. 212, Germaniastrasse 55, 8033 Zurich, Switzerland. They can also arrange tax-free exchanges as described in idea #48.) 50) Are you sitting on bonds that have appreciated substantially? Many investors are sitting on gains after the bull market of the last few years. There's a cute trick you can use if the bonds are currently selling at a premium over their face values. Sell your bonds and take the gain. Then you can buy the same bonds back. You bought these bonds at a premium, and the tax law allows you to amortize a premium over the life of the bond. So you get a tax deduction to offset the interest earned on the bonds. The closer a bond is to maturity, the higher the deduction will be. 51) You can deduct the loss on a bad stock investment, without taking yourself out of the market. Normally you cannot sell a stock, take the loss, then buy the stock back. The "wash sale" rules prevent you from taking the loss if the stock is purchased within 30 days of the sale. But the wash sale rules don't apply if you sell the stock and contribute the cash to your IRA. If you still like the stock, you can have the IRA repurchase it. 52) You may have purchased bullion coin investments in the 1970s and 1980s at prices substantially higher than today's levels. For instance, gold is now trading in the $400 per ounce range, less than half of its historic high of more than $800 per ounce. Silver is also trading much lower than its previous peaks. These low prices in tangible assets may not last for long. Because stock "wash sale" rules do not apply to coins, International Financial Consultants (IFC) has developed a program that enables you to take advantage of today's low prices to reduce your tax burden by taking losses on your coin investments to offset current ordinary income, or to shelter gains that you have realized on your other investments. Investors owning bullion coins that have declined in value can sell those coins to IFC, thereby creating a deductible loss, and will have the option, but not the obligation, to buy the same coins back from IFC, or can buy other, materially different coins or metals from IFC. Provided that the transaction meets the criteria set forth in the laws and regulations, any loss resulting from your sale or exchange can be deducted up to $3,000 of ordinary income, or can be deducted against capital gains on other investments, with the ability to carry unused losses forward to future years. This deduction will be available even if you exercise your option to repurchase the coins from IFC. Contact International Financial Consultants Inc., Suite 400A, 1700 Rockville Pike, Rockville MD 20852. (More information on IFC is at idea #79). 53) Buying into new passive investments also avoids the passive loss limit. Instead of buying new tax shelters in the future, you buy into new passive activities. But remember that passive activities are different from investments or portfolio income. You want to buy into partnerships or directly into businesses. Parking lots are frequently mentioned as good for the purpose because they produce high, reliable income and there is no question that they will be passive activities. Other passive investments, such as real estate income partnerships, have higher risk and even under the best assumptions will not produce much more income than the money market. A sideline real estate investment still reduces taxes for most taxpayers. The passive loss limitation does not apply to the first $25,000 of losses each year from real estate investments in which the investor actively participates. This means that the professional or salaried employee with one or two rental properties on the side can shelter a lot of income from taxes. The rental activity should be arranged so that there is no question of your participation being active. This means you should collect rents and arrange for repairs to be done. If you have reliable properties and tenants this shouldn't cause too many headaches. But the $25,000 loss allowance is reduced for investors with over $100,000 of other adjusted gross income. The loss is eliminated at $150,000 of adjusted gross income. If your income is beyond that, you are subject to the regular passive loss rules. 54) Oil and gas investments come through recent tax changes relatively untouched. Intangible drilling costs are still deductible as before, except for costs related to foreign properties and those incurred by integrated oil producers. The percentage depletion also is still intact except it is not allowed to offset lease bonuses, advance royalties, or any other amount payable without regard to production. In other words, you don't take the percentage depletion deduction until you actually start to receive income from the property. Oil and gas investors also get an exemption from the passive loss limitation. But the investor must have a "working interest" in the business and the form of ownership must not limit the investor's personal liability for the project. IRS regulations will later flesh out the definition of working interest, and it remains to be seen how active an investor must be before taking the oil and gas writeoffs against non-passive income. In short, oil and gas investments generally retain the rules in effect before tax reform. One rule worth recalling is that a cash investment in a drilling program is deductible in the year made only if the money is spent within that year and the first two and a half months of the next year. Investors should be able to find tax reduction opportunities in oil and gas. The question is whether these opportunities are worth the economic risk.