Analyzing Your Client's Financial Profile - Tax Issues

Income Tax
Income taxation can have a significant impact on your client's portfolio and financial plans. It is crucial that you fully understand the tax implications of the recommendations you make. An individual may be subject to one of these four types of income tax:

  • Ordinary income- This includes all income earned from salary, commission and business income. Some investment gains, such as bond interest and withdrawals from Traditional IRAs and company retirement plans, are taxed at "ordinary income" rates.
  • Capital gains - This refers to income resulting from the appreciation of a capital asset (e.g. stocks, real estate, coins). Capital gains are not realized until the asset is sold. Capital gains are classified as short term or long term:
    • Short term - Assets held for 12 months or less are considered short-term capital gains and are taxed at ordinary income rates.
    • Long term - Assets held for longer than 12 months benefit from reduced tax rates (based on your marginal tax bracket). Those in the lowest tax brackets (10% or 15%) pay only 5% capital gains tax rate, while those in the higher brackets (25% and above) pay only 15%.
  • Dividends - Prior to 2003, dividends were taxed at ordinary income rates, along with bond interest. Due to a change in tax law, "qualified" stock dividends (common and preferred) are now taxed like capital gains, with a maximum income tax rate of 15%. REIT dividends do not qualify for this special treatment.
  • Passive income - Income from sources such as real estate limited partnerships or directly owned (but professionally managed) real estate is taxable at ordinary income rates and can only be reduced by passive losses, not by capital gain losses.

Holding Period
Since the difference between short-term capital gains and long-term capital gains taxation rates is so significant, you need to understand exactly when a security is considered purchased and when it is considered sold.

  • The holding period begins the day after the security is purchased (not the settlement date).
  • The holding period ends the day of the sale.
  • It is important to keep detailed records of these dates, to ensure that a security is not sold too soon and thus qualifies for preferential tax treatment.

Cost Basis
Merely knowing the tax rates is not enough for an IA. A key concept to understand is cost basis, since the amount of capital gains to be taxed is calculated by subtracting the investor's cost from the sales proceeds.

To determine the cost basis of an investment, start with the original price (plus any transaction costs). Next, add the dollar value of dividends that were reinvested. This would apply to both stocks in a dividend-reinvestment program and mutual funds where dividends are automatically reinvested. Reinvested capital gains are also added to the cost basis for mutual funds.

Cost basis = Original Price + transaction costs + dividends

If you inherit an investment, your cost basis is the value of the asset as of the decedent's date of death. This is known as a stepped-up cost basis. Also, the holding period is always considered long-term, even if the deceased hadn't owned the investment for 12 months before death.

If you receive an investment as a gift, there are actually two different cost bases that apply:


  1. The actual cost basis of the giver
  2. The market value on the date of the gift.

The best way to explain how this works is to use an example. Let's say you are given shares of stock, and the original owner's cost basis was $70 a share. On the date of the gift, the shares are trading at $60. If you sell the shares in the future, the basis for a gain is $70 a share, and the basis for a loss is $60. If you sell the shares for a price between $60 and $70, you have neither a taxable gain nor a taxable loss.

Netting Capital Gains and Losses and Wash Sales
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