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Investment Tax Planning

Don't overlook the tax consequences when you make investment decisions.

Financial advisers recommend that you make investment choices based on factors such as return on investment, level of risk, and portfolio diversification – not on avoiding income taxes. Still, investing your money to gain the best possible return after taxes is a vital part of any investment strategy.

Capital gains

A capital asset is any property you can buy and sell. That includes stocks, bonds, and mutual funds, your home and other real estate, jewelry, cars, and collectibles. A capital gain is the amount of your profit when you sell an asset for more than it cost you. You have a capital loss, on the other hand, if you sell an asset for less than you paid to buy it.

Long- and short-term gains

If you own a capital asset for a year or less before you sell, any appreciation, or increase in value, will give you a short-term capital gain. Short-term gains are taxed as ordinary income, at your regular tax rate.

But if you own certain assets for more than a year before you sell at a profit, you have a long-term capital gain. Those gains are taxed at a maximum rate of 15% if your marginal tax rate is 25% or higher. If your marginal rate is 10% or 15%, capital gains are taxed at 5%. These rates apply to any gains after May 5, 2003, and are scheduled to be in effect until the end of 2008.

Deducting capital losses

You can combine your capital gains and capital losses – short-term gains with short-term losses and long-term gains with long-term losses – to offset, or reduce, the gains on which you owe tax. You may even wipe out all your gains and have a net loss.

If you have a net loss, you may be able to reduce your ordinary income, such as your salary, but there's a cap of $3,000 per year ($1,500 if you're married and filing separate returns). If your loss is greater than that amount, you can carry over the excess and deduct it against gains or ordinary income in later years.

Figuring gain or loss

You figure gain or loss by subtracting your basis from the proceeds of a sale. Basis is the price you paid for the item, plus the expenses of buying, holding, and selling it. For example, the commissions and costs of an investment transaction are subtracted from the proceeds of a sale when you figure a gain. If you received the item as a gift, your basis is the same as the giver's was. If you inherit an asset, your basis is the market value on the date of the giver's estate was valued.

ProceedsThe amount you get when you sell your asset
BasisThe original cost of the asset, plus the cost of buying, holding and selling it

= Gain or Loss

Here's how you would figure a capital gain:

$22,000Gross proceeds from the sale of stock
- $20,000Amount you paid for the stock
- $385Broker's commission and fees on sale

= $1,615Your capital gain

Holding stocks defers capital-gains taxes

While you're holding an investment, you don't pay tax on any increase in its value, or what's known as your paper profit or unrealized gain. The market price of a stock you bought for $5 a share may climb to $50, but the tax on that gain is deferred until you sell the stock and collect the proceeds. At that point, your gain is taxed at your capital gains tax rate. Of course, any profit you don't realize could disappear if the market value of the stock or other asset dropped.

The long and the short of it

An investor in the 35% tax bracket sells stock resulting in a capital gain of $20,000. She keeps $4,000 if she has a long-term gain.

Sell on or before one year
taxed at 35%
= $7,000 Tax Due
Short-term gains are taxed at your regular income tax rate
Sell after one year
taxed at 15%
= $3,000 Tax Due
Long-term gains are taxed at a maximum rate of 15%

Passive income

Passive income or passive losses come from businesses in which you aren't an active participant. These include limited partnerships, rental real estate, and other types of activities that you don't help manage.

Losses from passive investments can be deducted from income you earn on similar ventures. For example, you can use losses from rental real estate to reduce gains on limited partnerships. Or you can deduct those losses from any profits you realize from selling a passive investment. But you can't use passive losses to offset ordinary income or capital gains.

The gain of giving

If you make a charitable donation of property that has increased in value, such as stock or real estate, you may be able to deduct the market value on your income tax return and avoid capital gains tax on the appreciation. Check with your tax adviser about any restrictions that may apply to the amount you can deduct. In contrast, if a stock's value has dropped, you may decide to sell it, take the capital loss, and donate the proceeds of the sale. Then you can use the loss to offset other gains.

Once your child is over age 14, you may be able to gain on your taxes by giving the child stock or other assets that have appreciated in value while you owned them. If the child sells the asset, he or she may pay capital gains tax at a lower rate than yours. However, you'll want to keep the value of each year's annual gift to each child below $12,000, or $24,000 if you're married and file a joint return, to avoid gift taxes.

© 2004 by Lightbulb Press, Inc. All Rights Reserved.
This information is provided by Lightbulb Press, Inc. and does not express the views of Wells Fargo, Inc. or any of its affiliates. Wells Fargo is not responsible for the accuracy, completeness, or correctness of the information provided by Lightbulb Press, Inc. or other third parties.

This information is provided with the understanding that the authors and publishers are not engaged in rendering financial, accounting or legal advice, and they assume no legal responsibility for the completeness or accuracy of the contents. Some charts and graphs have been edited for illustrative purposes. The text is based on information available at time of publication. Readers should consult a financial professional about their own situation before acting on any information. • Lightbulb Press, Inc., 112 Madison Avenue, New York, New York, 10016, Tel: 212-485-8800, www.lightbulbpress.com.

Any tax or legal information in this website is merely a summary of our understanding and interpretations of some of the current income tax regulations and is not exhaustive. Investors should consult their tax advisor or legal counsel for advice and information concerning their particular situation. Wells Fargo Funds Management, LLC, Wells Fargo Funds Distributor, LLC, nor any of their representatives may give legal or tax advice.

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