I have met investors who made serious tax errors because they didn’t seek professional advice. One person had $78,000 of accrued interest from negative amortization on a rental property that became deductible when the loan was refinanced and paid off. However, the accrued interest was not properly reported by bank until several years later. When a property owner has a negative amortization mortgage the accrued interest is deferred until the loan is paid off or until the loan changes to a fully amortized loan. The interest can only be deducted when paid, assuming the taxpayer is using the cash method of accounting. However, if the bank forgot to disclose this on the form 1099 when the loan was paid off then the taxpayer would miss a huge deduction. Investors need to be alert since there is a three year statute of limitations for amending tax returns.
Investors should carefully check their mortgage documents for accrued, deferred interest from negative amortization and keep track of it so when the pay off the loan they can audit the 1099 for accuracy.
Other tax mistakes investors have told me about were losing a huge amount of money from stock market day trading (before they met me) and then assigning the losses all to one spouse during a divorce instead of assigning it to the higher income spouse who would have a greater probability of someday utilizing the deductions. These losses are limited to $3,000 a year, so stock and bond market capital losses are some of the worst tax problems that can occur. In this case they didn’t become aware of their mistake until after the statute of limitations so a huge benefit was wasted.
By contrast, if you sell a rental real estate property at a loss, the loss is fully deductible against all income because rentals are not subject to the $3,000 capital loss rule. However vacant land if never rented is subject to the $3,000 capital loss limit.
Gains on commodities and collectibles are taxed at 28% if a long term holding instead of the 15% (or 20%) rate for other capital assets.
The best mix of assets for tax purposes would be a combination of stocks held until one dies (to get a tax free basis step-up), rental real estate, tax free AMT free Muni bonds, and a modest sized owner –occupied home. Of course if the assets are overpriced then no amount of tax benefits justifies buying them. If assets are overpriced then the dominant decision factor would be to focus on avoiding risk of before-tax loss rather than seeking tax savings.
Other asset classes to examine would be Cash Value Life Insurance and Annuities, however the tax savings may be eaten up by the insurance company’s fees. Also Roth IRA’s, while not an asset class, are an interesting tool. Deferred Compensation from an employer may be interesting but it may backfire by converting long term gains into ordinary income while subjecting the owner to excessive risk of corporate bankruptcy. Thus this could be one of the worst tax traps.
If someone insists on being a short term trader then for tax planning it would be best to do that inside of a traditional IRA. That way if losses occur then the traditional IRA, indirectly speaking, provides an unlimited “deduction” for losses because when withdrawals are made and tax is paid the smaller account would mean less withdrawal income is generated over a lifetime (due to the losses). This brings up a point that even more important than tax planning is that one shouldn’t gamble with retirement assets; instead they should be in quality assets that have a reasonable risk instead of in a speculative venture doing day trading with an IRA.
If someone is an investor they need to get educated about taxes before they start topo invest. Once they have started it may already be too late to get the optimal outcome. Also once someone has started an investment they maybe too busy and preoccupied to study taxes and possibly too emotionally committed to their investment. Thus they may not be capable of getting the needed education. Investors need a financial planner to examine these issues before the investment is made.
Investors should seek independent financial advice from a Certified Financial Planner, CPA or Enrolled Agent about potential tax traps before buying an investment. Consider taking classes and reading books about taxes, although if you work 12 hours a day you won’t have the energy to do that. I wrote an article “Tax planning may improve investing”.