investment return

Optimizing Your Capital Gain Treatment Part 2

It’s a new world. When it comes to carried interest, real estate and collectibles, carefully document your purpose for holding these assets

Key Takeaways:

  • Long-term capital gains associated with assets held over one year are generally taxed at a maximum federal rate of 20 percent — not the top ordinary rate of 37 percent.

  • Just be careful if you are planning to sell collectibles, gold futures or foreign currency. The tax rate is generally higher.

  • The more you can document your purpose for holding your assets (at the time of purchase and disposition), the better your chances of a favorable tax result.

  • The deductibility of net capital losses in excess of $3,000 is generally deferred to future years.

There’s no shortage of confusion about the current tax landscape—both short-term and long term—but here are some steps you can take to protect yourself from paying a higher tax rate than necessary as we march into a new normal world.

 

Carried Interest

The Tax Cuts and Jobs Act lengthens the long-term holding period with respect to partnership interests received in connection with the performance of services. Profit interests held for three years or less at the time of disposition will generate short-term capital gain, taxed at ordinary income rates, regardless of whether or not a section 83(b) election was made. Prior law required a holding period greater than one-year to secure the beneficial maximum (20%) federal long-term capital gain tax rate.

Real estate

Real estate case law is too technical for the purposes of this article. Let’s just say the courts look at the following factors when trying to determine a personal real-estate owner’s intent:

  • Number and frequency of sales.

  • Extent of improvements.

  • Sales efforts, including through an agent.

  • Purpose for acquiring, holding and selling.

  • Manner in which property is acquired.

  • Length of holding period.

  • Investment of taxpayer’s time and effort, compared to time and effort devoted to other activities.

Unfortunately, the cases do not lay out a consistent weighting of these general factors. Always check with your legal and tax advisors before engaging in any type of real-estate transaction.


Collectibles

Works of art, rare vehicles, antiques, gems, stamps, coins, etc., may be purchased for personal enjoyment, but gains or losses from their sale are generally taxed as capital gains and losses. But, here’s the rub: Collectibles are a special class of capital asset to which a capital gain rate of 28 percent (not 20%) applies if the collectible items are sold after being held for more than one year (i.e. long-term).

Note that recently popular investments in gold and silver, whether in the form of coins, bullion or held through an exchange-traded fund, are generally treated as “collectibles” subject to the higher 28 percent rate. However, gold mining stocks are subject to the general capital gains rate applicable to other securities. Gold futures, foreign currency and other commodities are generally subject to a blended rate of capital gains tax (60 percent long-term, 40 percent short-term).

Bitcoin and other cryptocurrencies are treated as “property” rather than currency and will trigger long-term or short-term capital gains when the funds are sold, traded or spent. Cryptocurrencies are NOT classified as collectibles.

The difficulties arise if you get to the point that you are considered a dealer rather than a collector, or if you are a legitimate dealer but start selling items from your personal collection. In most cases, the following factors in determining whether sales of collectibles result in capital gain or ordinary income:

  • Extent of time and effort devoted to enhancing the collectible items

  • Extent of advertising, versus unsolicited offers

  • Holding period and frequency of sales from personal collection

  • Sales of collectibles as sole or primary source of taxpayer’s income

The Tax Cuts and Jobs Act, will end any further discussion about whether gain on the sale of collectibles can be deferred through the use of a like-kind exchange. The tax bill limits the application of section 1031 to real property disposed of after December 31, 2017.

Recommended steps to preserve capital gain treatment:

  • Clearly identify assets held for investment in books and records, segregating them from assets held for sale or development.

  • In the case of collectibles, physically segregate and document the personal collection from inventory held for sale.

  • Memorialize the reason(s) for a change in intent for holding: e.g., death or divorce of principals, legal entanglements, economic changes or new alternate opportunities presented.

  • If a property acquired with the intent to rent is sold prematurely, then retain documentation that supports the decision to sell: e.g., unsuccessful marketing and advertising, failed leases, news clippings of an adverse event or sluggish rental market.

  • If a property is rented out after making substantial improvements, then document all efforts to rent, and list or advertise it for sale only after a reasonable period of rental.

  • Consider selling appreciated/unimproved property to a separate entity before undertaking development. This would necessitate early gain recognition, but may preserve the capital gain treatment on the appreciation that’s realized during the predevelopment period.

  • Consider the application of Section 1237, a limited safe harbor, permitting certain non-C Corporation investors to divide unimproved land into parcels or lots before sale, without resulting in a conversion to dealer status.

Conclusion

Characterizing an asset as ordinary or capital can result in a significant tax rate differential. It can also affect your ability to net gains and losses against other taxable activities. So you must spend the time and effort needed to document the intent of the acquisition of an asset, as well as any facts that might change the character of the asset, during the holding period.

Sure, we’re all busy. But, in today’s new regulatory and tax landscape, don’t you think it’s worth taking the time to do so in order to potentially cut your future tax rate in half?

 

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

 

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.

 

Predictions About The Future

“I don't read economic forecasts. I don't read the funny papers.” — Warren Buffett

“One day, the world will indeed end. The sun will run out of hydrogen fuel, turn into a red giant star, and expand until it engulfs the earth. That is about 5 billion years in the future. In the meantime, you can safely ignore all other forecasts.” — Barry Ritholtz

It's just amazing how long this country has been going to hell without ever having got there. — Andy Rooney

It is very hard to ignore predictions about the stock market, especially when the forecast calls for rain. To make matters worse, the financial press often preys on our “fight or flight” instincts by featuring the forecasters’ doom-and-gloom predictions. After all, it’s what sells their stream of stuff. 

As we’ll describe today, the more urgently a financial pundit is pressing you to buy this or sell that based on imminent past or future events, the more reasons you’ve got to fight your impulse to react. As Dimensional Fund Advisors’ Jim Parker wrote about here, confusing fleeting trends with permanent conditions is like mixing up the difference between the weather and the climate.

What the Talking Heads Aren’t Telling You
If you think about hot financial predictions in a logical fashion, why would these prognosticators have to work at all if they could accurately predict the future? Why wouldn’t they use their insights to enrich themselves rather than tipping their cards to us? 

Someone with forecasting talent could implement financial instruments to leverage their assets for something like a 20:1 payoff. If they really did see a 20% correction coming, they could easily use leveraging to earn a 400% return, just as a few lucky souls did in the movie, “The Big Short.” They would only have to do this a few times before they could get rich quick and call it a day. (Of course, as we saw in “The Big Short,” you only have to be wrong once – or even not right soon enough – to be wiped out by leveraging!) 

Chicken Little Forecasting
Think of it this way: I could predict every blizzard in Boulder by forecasting that a blizzard is about to fall every time I saw a cloud in the sky. Similarly, a plucky prognosticator could predict an impending 10% market decline whenever there’s a hint of bad news on the horizon. Mind you, there’s no substantial evidence that every appearance of bad news causes a market decline, but because the markets tend to drop at least 10% about every 7 months for all sorts of reasons, our “sky is falling” Chicken Little faces not-bad odds of being correct now and then through random chance. 

The Track Records of an “Etch A Sketch” 
By now you might be thinking: “But won’t a false prophet eventually be found out?” Unfortunately, the answer is, probably not. Are you familiar with the classic Etch A Sketch? No matter how big a mess you make, you can wipe your slate clean in seconds. 

Financial forecasters seem to enjoy similar treatment. It seems as if there is little to no penalty when they’re wrong, because no one monitors their predictions or seriously calls them to task when they lead their followers astray.
 
Instead, whenever someone does get lucky and makes an important prediction or two that happens to come true, they are heralded as a guru and people flock to hear what they have to say next … at least until the next guru comes along and the last one is forgotten.  

Luck or Skill? 
If you’re up on your financial forecaster lore, you may remember Elaine Garzarelli, who predicted the 1987 stock market crash. Her seemingly prescient prediction allowed her to start her own mutual funds, which were eventually folded into other mutual funds or liquidated due to poor performance

We could cite countless other illustrations of yesterday’s financial superstars fading fast. Bottom line, when the talking heads on TV get a prediction right, we can’t know at the time whether it was due to luck or skill. What we do know is that, in markets that are highly efficient, it’s far more likely to be luck, as appears to be the case for Garzarelli. 

Our “What Have You Done for Me Lately?” Bias 
We also need to consider your own biases, especially recency bias. Behavioral finance informs us that investors tend to assume that recent market trends are more likely to happen again or to keep happening. This too can aggravate your tendency to give a financial forecast greater weight than it deserves. 

For example, whenever one corner of the market has underperformed for a while, we see forecasters predicting continued pain. “It’s the new normal,” they proclaim, wherever a downturn has lingered. We also see investors fleeing that holding and piling up on whatever has recently been doing well. 

Then the forecasts and the fund flows reverse when the tables turn. 

This is recency bias in action.  For example, as “Advisor Insights” blogger Matthew Carvalho described in April 2016, there were a host of dire market predictions in the beginning of the year. Some investors likely exited or remained out of the market as a result. Carvalho observed: “One prediction that was spot on came on January 1 from the Associated Press: Expect less and buy antacid. Looking backward, that was apt advice for daily market spectators; however, if you took a 3-month vacation and didn’t check your balance, you’d return thinking the first quarter was normal — no antacid needed.”

Perfect Timing … or Else
Another problem with fleeing the market in response to gloomy forecasts is that you must correctly time both your exit and reentry points. It may be tempting to sell when the market is down, but you’re selling low, incurring trading costs and potentially facing taxable gains. Then you have to determine when it’s time to jump back in. Most investors end up buying back in when prices are high, incurring another round of trading costs. 

Trying to successfully repeat this process over and over is expensive, frustrating and likely fruitless. According to this DALBAR study of investor behavior, market timing caused average investors to realize only a fraction of the stock market gain that would have been available to them. For the 20-year period ending December 2014, the average equity fund investor earned 5.19% annually while the S&P 500 Index returned 9.85% annually. It was even worse for the 30-year period with the average equity fund investor earning 3.79% annually and the S&P 500 returning 11.06% annually.

What’s an Investor To Do? 
We believe in the Efficient Market Hypothesis, which says that all available information is incorporated into the market very quickly. The markets aren’t perfectly efficient, but they’re efficient enough that your best chance to enjoy a successful investment experience is to forget the forecasts and focus on far more timeless advice: 

Invest for the long-term. Capture available market returns within your risk tolerances and according to the best available evidence. Aggressively manage the factors you can expect to control and disregard the ones that you cannot. 

These principles guide the actions we’ve advised all along. We will continue to embrace them unless compelling evidence were ever to inform us otherwise. They are the ones that serve your highest financial interests, which is our highest priority as your advisor.  


Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.



The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.

Negative Real Returns

Here is a nice article written by Dimensional Fund Advisors:

Even when the inflation-adjusted return on Treasury bills is negative, a relatively common occurrence, bond investors may still achieve positive expected real returns by broadening their investment universe.  CLICK HERE TO READ MORE:

 

Negative Real Returns.pdf


Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.
 


The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.