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Recent articles by Jeff Schnepper: • Don't let a cheatin' spouse stick you with the tax bill, 10/31/2004 • Cutting a deal with the IRS has gotten tougher, 10/31/2004 • IRS helps disabled hold on to financial health, 10/30/2004 More... |
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Related Articles The 2003 tax bill: see what's in it for you The myth of the marriage penalty 9 new tax cuts now in the pipeline Related Resources Check out our capital-gains planning tool How much will the 2003 tax bill save you? Use our estimator Sign up for MSN Money's tax newsletter |
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| 4 hidden traps in our tax code | |||||||||||||||
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Sometimes, its not what you dont know that gets you in trouble. Its what you think you know -- and then find out youre wrong about. By Jeff Schnepper Sometimes, its not what you dont know that gets you in trouble. Its what you think you know -- and then find out youre wrong about. Here are a number of pieces of our tax code where the general rule seems simple, but the minutia can get you in hot water. Dividends will be taxed at 15% or less -- but not always What's called a dividend today isnt always a dividend and may not qualify. What you want are qualifying dividends. This is a distribution of a corporations profit that has already been taxed to the corporation. Lets look at some examples where there may be some confusion. Mutual funds. Funds have, in the past, reported short-term capital gains as dividends. Both the gains and any dividends were taxed at ordinary rates rather than at the lower capital gains rates. Now, such distributions must be separated. Thats because short-term capital gains dont qualify for the lower 5%-to-15% rates. These are taxed at ordinary income tax rates. Margin accounts. Do you have a margin account with your broker? If so, you may have a problem. Your broker often lends out securities in such accounts to other investors who sell short using your stock. These borrower investors receive the dividends and reimburse you for what they receive. Sure, you end up with the same dollars, but these payments in lieu of dividends dont qualify as dividends. That means the payments will not be taxed at 5% or 15%. They'll be taxed at regular tax rates -- as high as 35%. The holding period. You just bought a stock and the company declares and pays a dividend. Then you sell the stock. Is your dividend subject to the maximum 15% rate? Maybe. Congress wants you to invest for the long term. To get the lower rate, you need to hold a stock for more than 61 days during the 121-day period that begins 60 days before the ex-dividend date. If you dont hold the stock a minimum of 61 days, theres no way youre going to qualify for the lower rates. Even if you hold the stock for more than 60 days, it has to be within that 121-day window to qualify. Remember, dont look for simplification in our tax law. You can deduct your SUV -- but not exactly The issue is equipment and small business. For years, small businesses putting new equipment into service -- computers, fax machines and, yes, some of these vehicles -- have been allowed to expense up to a total of $25,000 in the first year of service. In 2003, that expense -- called a Section 179 election was bumped to $100,000. Headlines have declared this to be an opportunity to buy and completely deduct the cost of a SUV in a single year. Not quite. Heres whats really going on. Many years ago, Congress passed a law limiting the annual deductions you can take on a luxury car thats used for business. A luxury car was defined as just about anything that had an engine. In 1986, for example, it covered cars costing as little as $11,250. For 2004 tax returns, the vehicle could cost as little as $17,500. To avoid covering real business vehicles, like trucks, the law was written so that cars with unloaded gross vehicle weight over 6,000 pounds were exempt from any limits. For trucks and vans, the standard was loaded gross vehicle weight -- the maximum recommended weight for the vehicle, fuel, passengers and cargo. SUVs are classified as trucks for this purpose. So, if your vehicle weighs more than 6,000 pounds, its not covered by any limitations. It has nothing to do with a special break for SUVs. Its only a weight issue. Thus, a sufficiently heavy Rolls Royce or a Cadillac Escalade used for business purposes might qualify. (The specifications of an Escalade ESV say its curb weight is 5,869 pounds. Surely, you could find a way to add 132 pounds so that its unloaded weight meets the 6,000-pound threshold.) The American Jobs Creation Act of 2004 further limited your deduction. As of October 23, 2004, the $100,000 election to expense has been reduced to only $25,000 for SUVs unless they weigh more than 14,000 pounds. If your SUV weighs 6,000 pounds or less, sorry. Youre still covered by the limitations. Your maximum first years deduction for a vehicle used 100% for business is capped at $10,910. If you buy the two-wheel-drive standard Escalade weighing just 5,400 pounds and costing $55,000 (plus taxes sand fees), it might take 24 years to fully depreciate. So, stop saying its an SUV thing. It isnt. This tax break is a weight thing. And that weight is becoming heavier. It pays to borrow the cash to invest -- but not necessarily The general rule with leverage (using borrowed money to finance your investments) is that any time your yield exceeds you cost of money, borrow! But this becomes even more advantageous if youre deducting the interest cost on margin loans at 35% while being subject to a maximum 15% tax on your earnings. You can actually win even if your yield is lower than your cost of money. For example, borrow $10,000 at 5% and your interest is $500. At a 35% tax rate, your deduction reduces your net after tax cost to only $325 (65% of $500). If your $10,000 is invested at 4.5%, youll have $450 in income. Taxed at a 15% rate, that leaves you with $382.50 (85% of $450). Thats $57.50 more than the cost of borrowing the money! But theres a trap here:
Transferring assets to your kids will cut your taxes -- sort of Heres the deal. Once your kids reach age 14, their investment income is taxed to them at their own rates, which are often lower than your own. Those normally in the 10% or 15% brackets will pay only 5% on long-term capital gains. And as of Jan. 1, 2008, the 5% rate drops to zero. Your epiphany? Transfer stock pregnant with capital gains to your lower bracketed kids and have them sold in 2008 for zero tax. What a great way to finance college or any other potential expense! Whats missing? Well, this: Its now the kids money. The kids might consider Cancun more attractive than a campus library. Depending on the size of the transfer, measured in fair market value, you might incur a gift tax liability. In any case, the bigger the transfer, the greater the negative impact on potential college aid based on need. Your kids assets and income count more heavily than does your own. Now, lets add the new tax law to the picture. How confident are you of a zero tax in 2008? Thats four or fewer years from now. Well have another presidential elections before 2008 is over. I remember when they promised that Social Security was never going to be taxed. It may be a good idea. But, unless I needed the dollars now, Id wait until it was closer to 2008 before Id make any irrevocable transfers. Besides, your maximum tax is now down to 15%, and I rarely hear of anyone going broke taking profits. | |||||||||||||||
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