Tax time is a day of reckoning for investors, when Uncle Sam demands his slice of interest, dividends and capital gains. In most cases the calculations are straightforward. But some types of assets throw curve balls – tax bills that defy logic.
In some cases, offbeat tax issues are the price for wandering off the beaten track of stocks, bonds and mainstream funds. Other cases seem like a slap in the face, like an unexpected bill for a plain vanilla holding like a U.S savings bond.
But the rules are the rules, so investors should study up when choosing a new type of holding, avoid waiting to the last minute to prepare the tax return, and have enough cash available for a surprise tax bill.
Here are a few tax surprises that could trip you up:
MLPs in IRAs. “Most folks think that anything that happens inside of IRAs isn’t taxable. While that’s mostly true, certain investments throw off a type of income that does end up causing tax headaches,” says Ben Birken, a planner at Woodward Financial Advisors in Chapel Hill, North Carolina. “This is called unrelated business taxable income (UBTI), and it’s most often associated with income from master limited partnerships.”
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MLPs are funds that own energy infrastructure like pipelines, refineries and storage tanks. To avoid tax at the company level, they pass most of their income onto shareholders, so they appeal to income-oriented investors. UBTI is income from something not directly related to the MLP’s main business – like a lunch stand at a refinery.
“Each taxpayer is allowed a $1,000 limit on UBTI in their IRAs. But above that, you’re looking at a taxable event,” Birken says.
Investors are wise to find out whether the MLP typically disburses UBTI. Issuance of a Form K-1 is a tip-off.
Real estate investment trusts. REITs are funds that own real estate like apartments and office buildings, and they pass most income onto shareholders. Like MLPs, they are sought for their high yields. But investors need to be aware that not all REIT dividends are the same, says, Scott K. Laue, financial advisor at Savant Capital Management, a wealth management firm in Rockford, Illinois.
Some REIT income is qualified dividends, which are taxed at 15 percent for most investors, while others are ordinary dividends taxed at higher income tax rates, Laue says.
“This sometimes creates unwelcome surprises come April 15th,” he says.
The REIT’s track record will tell you what to expect.
Reinvested dividends. Nothing exotic about this one – it can trip anyone with ordinary stocks or funds. Basically, dividends in taxable accounts are taxed the year they are received, so they should not be taxed again if used to buy more shares.
If you spent $100 a share and received $50 in dividends over a couple of decades, and used that income to buy more shares, your cost basis would be $150, not $100. Should you sell the shares for $300, your taxable capital gain would be $150, not $200. Failing to keep track of the reinvestment would produce a bigger tax bill.
“Keeping track of reinvested dividends is particularly important if you own a stock or fund for a long time and reinvest dividends along the way,” says Philip H. Weiss, principal at Apprise Wealth Management in Phoenix, Maryland.
These days most brokerages and fund companies track reinvestments and report a correct cost basis on the Form 1099 after shares are sold. But long-term investors should make sure the calculations are not thrown off by events, such as transferring assets to a new financial company which won’t know about previous reinvestments unless it is told.
Cryptocurrency. Computerized money like bitcoin can have a murky tax status, according to Anthony E. Parent, founding partner at Parent & Parent, a tax firm in Wallingford, Connecticut.
“The SEC claims certain cryptos are securities, the Financial Crimes Enforcement Network (FinCEN) states they are currency and the IRS says that cryptocurrencies should not be taxed as currency but rather as property,” he says.
One consequence, he says, is that cryptos are not subject to the wash-sale rule, which prohibits investors from claiming a loss on an ordinary investment like a stock or fund if the same security or a “substantially similar” one is purchased within 30 days before or after the sale. So this is a case where quirky tax treatment can be beneficial – you can book a bitcoin loss and immediately buy more coin to benefit from a quick rebound.
Previous capital gains. A capital gain is figured by subtracting the original purchase price, or basis, from the net proceeds after a sale. But this can be irksome for an investor who become a U.S. citizen in the meantime, Parent says. The basis is the cost when the asset was acquired, not its value when the investor became a citizen.
“That is by far the most obnoxious thing in the tax code,” he says, “The US government claims it is entitled to gains you enjoyed when you weren’t subject to the tax jurisdiction of the U.S.”
Real estate in an IRA. Many investors don’t know that it’s possible to purchase investment property in an individual retirement account, but it is. This approach can save annual tax on income that is paid into the IRA and kept there. But it can cost you in other ways, such as restrictions on otherwise valuable depreciation deductions, according to Tom Wheelwright, CEO of tax advisory firm WealthAbility and author of the book “Tax-Free Wealth.”
“Depreciation is the big benefit of real estate investing. If you are not a real estate professional or don’t have other passive income, you may be severely limited on the losses you can use against other income” if the property is in an IRA, he says.
Brian J. Thompson, a CPA and tax attorney in Chicago, says real estate investments can be a headache even without IRA complications.
“The federal income tax treatment of passive activity losses and income can come as a surprise to owners of rental real estate,” he says.
Merely owning the property, but not managing it, could trigger this tax treatment, which can limit losses claimed on taxes to no more than the income reported.
Inherited savings bonds. The investor in U.S. savings bonds can elect to pay tax as interest is accrued year by year, or defer it until the bond is redeemed, says Jacob D. Kuebler, Owner of BlueStem Financial Advisors in Champaign, Illinois.
“We commonly see investors get tripped up on the reporting of U.S. savings bonds after an inheritance,” he says. “While it is most common to choose to defer income until cashing the bonds in, you need to confirm the method used by the original owner – the decedent – and the estate. If the interest was deferred until maturity by the decedent and estate, you as beneficiary will pay the tax upon cashing them in.”
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