SHARE YOUR INVESTMENT LOSSES WITH UNCLE SAM

The tax code is built to let you use the money you lost to minimize your tax bill. So be patriotic. Put that law to work and save money at tax time.

This is a time to stand up for your country — the great United States of America.

I’m proud to live in a nation that has allowed me the opportunity to work my way out of Southwest Denver and earn an income that mandates quarterly tax payments, each five times the total income my father earned in a whole year following World War II.

In fact, some people are so proud of this nation that they actually make voluntary (and deductible) tax contributions to reduce our national debt. Voluntary contributions to the U.S. Debt Reduction Fund since 1961 have totaled almost $40 million.

But I must confess that I empathize with the late entertainer Arthur Godfrey, who once remarked, “I am proud to be paying taxes in the United States. The only thing is — I could be just as proud for half the money.”

The question then is, can we continue to be proud and bring our tax bills down to something closer to half the money? Well, it’s tax management time, time to make those decisions that cut tax bills and ensure that you use your money in the most efficient manner possible.

Let’s take a look at planning to minimize the tax damage in two areas that loosely come under the umbrella of investing.

Share the Loss

Remember when you had a stock portfolio worth more than a ticket to the movies? Here’s a chance to share some of that pain with your friends at the Internal Revenue Service.

My general rule with investments is that if you wouldn’t buy the security today at its current price, it’s time to think about selling it.

Capital Losses

Losses on sales of capital assets offset capital gains (Remember when we used to have those?) on a dollar-for-dollar basis. That makes those gains potentially tax-free. Any excess losses can offset as much as $3,000 in other non-capital income. Losses in excess of this $3,000 annual limit are carried forward into your pot. (Republicans may try to expand that break in 2005.) How much is the $3,000 loss worth at tax time: if you're in the 25% bracket this year, it’s worth $750. If you're in the 28% bracket, it's worth $840. At the top rate of 35%, the deduction trims your taxes by $1,050 — more than a third of the total loss.

Sell those securities now and capture the tax benefit of the reduction in price. If you believe the shares have substantial potential future appreciation, you can have your cake and eat it too. It’s easy: Repurchase the stock (or fund) after locking in the loss deduction.

But beware of the “wash sale” rules. They disallow any current deduction if you buy the stock (or fund) either 30 days before or 30 days after the loss sale. So wait 31 days after your loss sale to escape this tax trap.

One way to avoid the wash sale rules may be to sell the loss security in your taxable account and then immediately repurchase it in your IRA or qualified retirement plan. Since these plans constitute entities “separate” from “you” for tax purposes, the wash sale prohibition shouldn’t apply.

Municipal Bond Swaps

If you own tax-free bonds that have fallen in value, consider a municipal bond swap. That’s a strategy where you sell your “loss” bonds and buy equivalent, but not identical, bonds to replace them. You maintain the same risk exposure and yield, but, because the bonds aren’t the same, you avoid the wash sale limitations.

You get the same cash flow from the interest payments and the same full principal at maturity. But you also now get a tax deduction. It’s a win-win situation for everybody, except the IRS.

Minimize the Hit From the Alternative Minimum Tax

What can be more fun than watching your portfolio dissolve and then finding you have to pay taxes on dollars you no longer have? Welcome to the netherworld of the Alternative Minimum Tax (AMT).

The AMT is a special add-on tax. The IRS slaps you with it if you take too many deductions in specific categories (called “preferences”) or if you engage in certain specified activities. It’s a flat 26% or 28% tax on an augmented Alternative Minimum Taxable Income.

One of those “preferences” is the spread between the exercise price and the fair market value of stock acquired under an Incentive Stock Option Plan. So, if the exercise price is $100 per share and you exercise your incentive stock options when the stock has a fair market value of $250, the $150 difference may subject you to the AMT.

That’s discomforting when the stock is at $250, but if the stock drops to $75, it’s an absolute disaster! You’ve not only lost your appreciation, but your investment is worth less than what you originally paid. And then, here’s the capper: You have to pay additional tax.

What can you do? Take a deep breath and recognize that under the AMT, any additional income you earn will be taxed at a 26% or 28% rate.

If you’re normally in a bracket higher than that, this is the time to accelerate income. Consider taking that bonus this year rather than next year, when it may be subject to tax at a higher rate. If you’re self-employed, send out your end-of-year bills in November rather than at the end of December.

Clearly take that additional earned income if you’ve hit the ceiling on Social Security contributions. For 2003, any earned income that exceeds $87,000 won’t be subject to Social Security. (The level is adjusted every year for inflation.) If you’re self-employed, that saves you 12.4% in taxes you won’t have to pay. If you’re an employee, the savings drop to 6.2% . . . but that’s because your employer would be liable for the other 6.2%.

Alternatively, defer taking any deductions. If you’re subject to the AMT, those deductions will save you only 26% to 28%. Deferring them into next year, when you won’t be subject to the AMT and will be in a higher tax bracket, will put more money in your pocket.

I understand that these suggestions are the exact opposite of what is normally suggested. But the AMT puts you into another dimension where the rules are reversed.