One tax topic we discuss with clients each year is the treatment of their capital gains and losses. Much of what you own is a capital asset including a home, personal use items like household furnishings, and stocks or bonds held as investments. Most people buy and sell assets without ever considering the tax consequences at the time. 

To help you better understand capital gains and losses, here are 10 facts everyone should know:

1. Almost everything you own and use for personal or investment purposes is a capital asset.
2. Capital gain or loss is the difference between your basis and the amount you receive when you sell that asset. Basis is typically what you paid to purchase the asset.
3. You can deduct losses on the sale of investment property but not on the sale of personal-use property.
4. Capital gains and losses are either short-term (owned less than 1 year) or long-term.
5. You must include all capital gains in your taxable income.
6. If your long-term gains are more than your long-term losses, the difference between the two is a net long-term capital gain. If your net long-term capital gain is more than your net short-term capital loss, you have a net capital gain.
7. If you have a net capital loss, you are limited to deducting $3,000 per year if you file as married filing jointly and $1,500 if you file separately or are single.
8. You may carry excess losses over to the next year.
9. Capital gains and losses for nonbusiness assets are reported on Form 8949 and summarized on Schedule D.
10. Tax rates on capital gains are typically lower than ordinary income tax rates.

For taxpayers there is an important distinction between what the IRS considers a hobby and what is considered a business. Internal Revenue Code Section 162 allows the deduction of ordinary and necessary business expenses if they result from a trade or business. On the other end of the spectrum, Code Section 183 limits the deductions for taxpayers related to activities not engaged in for profit. The expenses may only be deducted to the extent of gross income from the Section 183 activity.

Determination of Business or Hobby

Generally a business is entered into for profit. In order to be characterized as a business, there must be intent to make a profit. A hobby may be entered into for recreation, not to make a profit. The IRS has provided nine factors to help determine if a business is operated for a profit:

• Whether the activity is carried on in a businesslike manner.
• Whether the time and effort put into the activity indicate that the intent is to make a profit.
• Whether the taxpayer depends on the income from the activity to support his/her livelihood.
• Whether losses from the activity are due to circumstances beyond control (or are normal in the startup phase for that type of business).
• Whether methods of operation are changed in an attempt to improve profitability.
• Whether the taxpayer or the taxpayer’s advisors have the knowledge necessary to carry on the activity as a successful business.
• Whether the taxpayer was able to make a profit in similar activities in the past.
• Whether the activity makes a profit in some years and how much profit it makes.
• Whether the activity is expected to make a future profit from the appreciation of the assets used in the activity.

In addition to the nine factors listed above, the IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five years, including the current year. (An exception would be for activities that consist primarily of breeding, showing, training or racing horses, the IRS looks for a profit in at least two of the last seven years.)

The taxpayer has the burden of proof related to proving the required profit motive. A court will weigh all the facts and circumstances, with greater weight given to objective facts than to the taxpayer’s mere statement of intent.

Limits on Deductions for a Hobby

Deductions from hobby activities are limited to the gross income from that activity. If an overall loss occurs for a hobby activity during a tax year, this loss cannot be used to offset other types of income.

The deductions for hobby activities must be claimed as itemized deductions on Schedule A of Form 1040. Therefore, a taxpayer must itemize deductions to deduct any expenses related to the hobby activities. They must be taken in the following order and only to the extent stated:

1.  Deductions that a taxpayer may take for personal as well as business activities, such as home mortgage interest and taxes. These may be taken in full. They should be listed on the correct lines on Schedule A.

2.  Deductions that do not result in an adjustment to basis, such as advertising, insurance and wages. These may be deducted to the extent gross income for the activity is more than the deductions from the first category.

3.  Deductions that reduce the basis of property, such a depreciation and amortization. These are taken last and only to the extent that gross income for the activity is more than the deductions taken in the first two categories.

Deductions in the second and third category must be claimed as miscellaneous deductions on Schedule A. That makes them subject to the 2% of adjusted gross income (“AGI”) limit. What this means is that in addition to the limits already discussed, the deductions must also be greater than 2% of a taxpayer’s AGI before any deduction can be claimed.

The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.

Conclusion

Hobbies do not receive favorable tax treatment by the IRS, so it is important to determine if an activity will be deemed a business or a hobby for income tax purposes. To be a business, the activity must be carried on with the intent of making a profit. An activity that is not a business will have limits on the amount of deductions it can take, and any losses from the activity cannot be used to offset other types of income. 

A trust is a versatile estate planning tool. It’s a vehicle for transferring wealth to the next generation in a tax-efficient manner. It can also provide incentives for your beneficiaries, serve as a financial “safety net” for your family, protect assets from creditors, achieve your philanthropic goals and leave a lasting legacy.

But no matter how well it’s designed and drafted, a trust won’t reach its full potential unless all of the stakeholders — grantor, trustee and beneficiaries — understand the trust’s goals and their roles in achieving them.

Grantor

No one understands the goals of a trust better than you, the grantor. But it’s critical that you communicate your goals to your advisors and understand how the trust will achieve them.

You should also educate yourself about the trustee’s duties and responsibilities to ensure that you select the right person for the job. You want to be sure, for example, that your trustee possesses the requisite financial, business, organizational and interpersonal skills.

It’s also important to consider potential conflicts between the trustee and the beneficiaries, particularly if the trustee is a family member. To avoid conflicts and ensure the trustee is qualified, it may be desirable to engage a professional trustee, such as a bank, trust company, attorney or financial advisor.

Trustee

Once you’ve identified potential trustees, you should educate them about what’s involved so they can make an informed decision about whether to accept the job. Some people, for example, may feel that they’re not qualified to manage investments or that they’re too close to the family to make objective decisions regarding distributions and other matters.

It’s also critical to educate the trustee about what you hope to accomplish with the trust. Although it’s possible to include very specific instructions in the trust document, often trusts are more effective if the trustee has broad discretion in managing and distributing trust assets. Educating the trustee helps ensure that he or she will exercise this discretion with your goals and principles in mind.

Beneficiaries

Don’t underestimate the importance of educating a trust’s beneficiaries. So long as they’re old enough, they shouldn’t be simply passive recipients of your wealth. Make sure they understand your goals and how the trust will provide financial security for them and their dependents down the road.

This is particularly critical if the trust is required to provide beneficiaries with withdrawal rights in order to qualify contributions for the $14,000 annual gift tax exclusion. Although you can’t ask your beneficiaries to agree not to exercise their withdrawal rights, you should educate them about the long-term benefits of keeping assets in the trust.

Providing beneficiaries with financial training and educating them about their rights will enable them to monitor trust performance (particularly after you’re gone) and, if necessary, replace the trustee. It’s also a good idea to set up periodic meetings between the trustee and beneficiaries to keep the lines of communication open.

Read the owner’s manual

A trust is a powerful estate planning tool. But like any other tool, it won’t produce the best results unless all stakeholders learn how to use it properly.  

It’s no secret that the cost of a college education continues to soar. Taxpayers with grandchildren often want to help for the education costs of their grandchildren, but it’s important to structure the payments correctly so that they don’t have negative gift and estate tax consequences. This article contains three strategies to help a grandparent pay for the education of a grandchild. 

1. Make direct tuition payments.

A simple but effective technique is to make tuition payments on behalf of your grandchild. So long as you make the payments directly to the college, they avoid gift and generation-skipping transfer (GST) tax without using up any of your gift or GST tax exclusions or exemptions.

But this technique is available only for tuition, not for other expenses, such as room and board, fees, books and equipment. So it may be desirable to combine it with other techniques.

A disadvantage of direct payments is that, if you wait until the student has tuition bills to pay, there’s a risk that you’ll die before the funds are removed from your estate. Other techniques allow you to set aside funds for future college expenses, shielding those funds from estate taxes.

If your grandchild is planning to apply for financial aid, also be aware that most schools treat direct tuition payments as a “resource” that reduces financial aid awards on a dollar-for-dollar basis.

2. Create grantor and Crummey trusts.

These trusts offer several important benefits. For example, they can be established for one grandchild or for multiple beneficiaries, and assets contributed to the trust, together with future appreciation, are removed from your taxable estate. In addition, the funds can be used for college expenses or for other purposes.

On the downside, for financial aid purposes a trust is considered the child’s asset, potentially reducing or eliminating the amount of aid available to him or her. So keep this in mind if your grandchild is hoping to qualify for financial aid.

Another potential downside is that trust contributions are considered taxable gifts. But you can reduce or eliminate gift taxes by using your annual exclusion ($14,000 per recipient; $28,000 per recipient for gifts by married couples) or your lifetime exemption ($5.43 million in 2015) to fund the trust. To qualify for the annual exclusion, the beneficiary must receive a present interest. Gifts in trust are generally considered future interests, but you can convert these gifts to present interests by structuring the trust as a Crummey trust.

With a Crummey trust, each time you contribute assets, you must give the beneficiaries a brief window (typically 30 to 60 days) during which they may withdraw the contribution. Curiously, the law doesn’t require that you notify beneficiaries of their withdrawal rights. Notification, however, is typically recommended.

If a Crummey trust is established for a single beneficiary, annual exclusion gifts to the trust are also GST-tax-free. 

3. Consider a Section 2503(c) minor’s trust.  

Contributions to a Sec. 2503(c) minor’s trust qualify as annual exclusion gifts, even though they’re gifts of future interests, provided the trust meets these requirements:

• Assets and income may be paid to or on behalf of the minor before age 21,
• Undistributed assets and income will be paid to the minor at age 21, and
• If the minor dies before reaching age 21, the trust assets will be included in his or her estate.

When the beneficiary turns 21, it’s possible to extend the trust by giving the minor the opportunity to withdraw the funds for a limited time (30 days, for example). After that, contributions to the trust no longer qualify for the annual exclusion, unless you’ve designed it to convert to a Crummey trust. Then, so long as you comply with the applicable rules, gifts to the trust will qualify for the annual exclusion.

Conclusion

While this is not an all-inclusive list, these ideas could be beneficial for some taxpayers and their beneficiaries. These ideas offer suggestions for paying the high costs of education while helping to limit a taxpayer’s estate and gift tax exposure. 

No matter how much time you invest in designing an estate plan that reflects your wishes, your efforts will be for naught if your family can’t find your documents. Here are several tips for ensuring that critical documents are readily accessible when needed:

Wills and trusts

Ask your accountant, attorney or other trusted advisor to keep your original will, living trust and other trust documents; and provide your family with his or her contact information. Be aware that it’s not advisable to place your will or living trust in a safe deposit box, however, as state law and bank policy will likely require that you present the original document or a court order to obtain access.

Financial documents 

Make it easy for your family or other representatives to find life insurance policies; tax documents; deeds to real property; bank, brokerage, retirement account and credit card statements; stock certificates; and other important documents. Also provide contact information for key advisors, such as real estate attorneys, accountants, brokers and financial advisors.

There are many options for providing your loved ones with access to this information, including:

• Renting a safe deposit box and instructing your family on how to obtain access,
• Storing documents in a fireproof lockbox and providing your family with the location and the key or combination, and
• Uploading digital backups of key documents to an online storage system. These systems provide family members or other representatives with access in the event you die or become disabled.

Health care documents 

Consider providing “duplicate originals” or copies of powers of attorney, living wills or health care directives to the people authorized to make decisions on your behalf. You might also ask your physicians to keep duplicate originals or copies with your medical records.

Preparing for retirement may be on your mind – and it should be. But have you thought about helping prepare your kids or grandkids for their retirement? Setting up a Roth individual retirement account for your teen can be a smart and rewarding move to consider at tax time, and you don’t have to be wealthy to do it.

High-school students with earnings from a summer job or babysitting probably aren't thinking of putting money away for decades. But you might plant the retirement-planning idea by funding a small Roth IRA for the teen—or by offering to match or put aside $2 or $3 for every $1 of taxable income the teen contributes.

There's no deduction for funding a Roth, but it differs from a traditional IRA in that you contribute with after-tax money but pay no taxes on withdrawals, meaning all growth is tax-free. A teenager working part-time will have one of the lowest tax rates, making it a good trade-off to pay taxes on contributions now rather than at retirement when the total and the tax rate will be much higher. And for your teen, that means decades of earning interest on interest which can result in a nice nest egg when they are ready to retire.

There are some requirements to establish and contribute to an IRA for your teen:

• The teen must have income from a job – allowances, even for chores around the house, don’t count.
• The IRA contribution can be as much as the teen's taxable pay from work in a given year or $5,000, whichever is less.
• The account can be set up and funded as late as the tax-filing deadline – April 15^th.

If you are self-employed, you can employ your children, pay them a salary and open a Roth on their behalf. Just make sure they do real work for a reasonable wage and you file W-2 forms reporting their earnings to the Social Security Administration.

Even with all of the benefits, it may be challenging to convince your teen to save now for retirement that is decades away. It may help to share what you have done towards your own retirement – good planning or poor. It also helps to paint a picture by providing some examples of what putting a certain amount away now and contributing to it over the years may mean in terms of real dollars for their future.

If you have questions about how best to help your teen (or you yourself) prepare for retirement, please contact us.

The Roth IRA is widely considered one of the greatest gifts the U.S. Congress has ever given to taxpayers. With a Roth IRA, contributions are made with after-tax dollars and, therefore, we do not receive an upfront tax deduction for the contribution. In return for not getting a tax deduction, the taxpayer gets something more significant – qualified distributions can be withdrawn tax free. Qualified distributions are distributions that occur after a five-year waiting period has elapsed and a triggering event has occurred. The triggering events are either the attainment of age 59½, death, disability, or a first time home purchase. Not only are your initial contributed amounts withdrawn tax free but all of the future appreciation in the Roth IRA account value escapes taxation as well.      

There is a little known provision in the Internal Revenue Code that can provide a huge income tax advantage for certain taxpayers in the right circumstances. Although conventional wisdom tells us to roll over our retirement account assets to a rollover IRA account when we leave an employer or retire, the availability of the Net Unrealized Appreciation (NUA) tax strategy requires very careful consideration before we roll over these assets. 

Internal Revenue Code Section 1031 exchanges have been very popular with taxpayers for many years. This Code section allows taxpayers to defer recognition of gain on the disposition of assets by participating in a like-kind exchange (“LKE”) transaction. There are several rules that a transaction must meet in order to qualify as an LKE. This article covers the basic requirements that must be met in order to defer recognition of gain on disposal of assets until a later date. 

The Basics of Section 1031 Exchanges

The first hurdle for an exchange of property to qualify as an LKE is that it must involve qualifying property. Qualifying property includes property used in a trade or business and property held for investment. Property used for personal purposes, stocks, bonds, notes, inventories , and partnership interests do not qualify for a Section 1031 exchange.

In addition to the requirement that the transaction must involve qualifying property, it must also involve like-kind property. Like-kind properties are of the same nature or character, even if they differ in grade or quality. Exchanging real property for real property would qualify as an exchange of like-kind properties; however, exchanging real property for tangible personal property would not qualify as an exchange of like-kind properties. Depreciable tangible personal property needs to be either like-kind or like-class to qualify for LKE treatment. To be considered like-class properties, the assets must be within the same General Asset Class or Product Class.

The basis of the property received in an LKE transaction is generally the same as the adjusted basis of the property given up, however, see the discussion below for partially nontaxable transactions.

Deferred Exchanges

A deferred exchange involves an exchange of like-kind assets that is completed over a period of time. Deferred exchanges are more complex, and additional requirements apply. There are time limits to meet in order for a deferred exchange to qualify as a Section 1031 exchange. The first time limit provides a taxpayer 45 days from the date the relinquished property is sold to identify potential replacement properties. The identification must be in writing, signed by the seller, and delivered to a person involved in the exchange (for example, the seller of the replacement property or a qualified intermediary). The second time limit requires that the replacement property must be received and the exchange completed no later than 180 days after the sale of the relinquished property or the due date (with extensions) of the income tax return for the year in which the relinquished property was sold, whichever is earlier. It is important to note that the replacement property will not be treated as like-kind property unless these identification and the receipt requirements are met.

Additionally, if the transferor actually or constructively receives money or unlike property in full consideration for the property transferred prior to the receipt of replacement property, the transaction is treated as a sale rather than a deferred exchange. Using a qualified intermediary (“QI”) can serve as a safe harbor against actual or constructive receipt.

A qualified intermediary is a party who enters into a written exchange agreement with the taxpayer. The written exchange agreement requires that the QI:

1. Acquires the relinquished property from the taxpayer,

2. Transfers the relinquished property,

3. Acquires the replacement property, and

4. Transfers the replacement property to the taxpayer.

The written exchange agreement must expressly limit the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or unlike property held by the QI before the end of the exchange period.

Beware: Some Exchanges are Only Partially Nontaxable

If money or unlike property, referred to as boot, is received in addition to the like-kind property and a gain is realized on the transaction, the exchange will be considered only partially nontaxable. Gain must be recognized equal to the lesser of the boot received or realized gain. If a loss is realized on the transaction, no loss can be recognized.

In calculating the realized gain, any liabilities assumed by the other party must be added to the amount realized. Any liabilities of the other party assumed by the taxpayer should be subtracted from the amount realized.

Example: A taxpayer exchanges business property with an adjusted basis of $32,000 for like-kind property. The property was subject to a $4,000 mortgage. The fair market value (“FMV”) of like-kind property received was $36,000. In addition, the taxpayer received $1,500 in cash and paid $500 in exchange expenses. The other party agreed to pay off the mortgage. How much gain should be recognized on the transaction?

The recognized gain on the transaction is $5,000.

The basis of the property that a taxpayer receives (other than money) in a partially nontaxable exchange is the total adjusted basis of the property given up, with some adjustments. Add to the basis any additional costs incurred and any gain recognized on the exchange. Subtract from the basis any money received and any loss recognized on the exchange. The basis is allocated first to the unlike property, other than money, up to its FMV on the date of the exchange. The remainder is the basis of the like-kind property.

LKE Transactions Involving Related Parties

There are special rules for LKE transactions between related persons. Under the rules, if either party disposes of the property within two years after the exchange, the exchange is disqualified from LKE treatment. In that event, the gain or loss on the original exchange must be recognized as of the date of the later disposition.

Related persons include members of the taxpayer’s family, a corporation owned greater than 50% by the taxpayer, and a partnership owned greater than 50% by the taxpayer. The two-year holding period begins on the date of last transfer of property that was part of the LKE transaction.

Conclusion

As discussed in this article, it is difficult to comply with the rules of Section 1031 related to a like-kind exchange transaction. Although there are many restrictions in place to meet the requirements of a like-kind exchange transaction, the benefits of deferring gain on an exchange can be great for taxpayers. For that reason, these transactions have been very popular for a number of years.