Financial Advisory Through the 1040

1. Financial Advisory Through the 1040 Presented by Daniel S. Cook, CPA, CFP

2. Disclosure • This presentation is intended for reference only. As the information is designed solely to provide guidance to the readers, it is not intended to be a substitute for someone seeking personalized professional advice based on specific factual situations. • Although Cook Financial Designs, Inc. and Daniel S. Cook, PLLC has made every reasonable effort to ensure that the information provided is accurate, its owner makes no guarantees, expressed or implied, on the information provided. The reader accepts the information as is and assumes all responsibility for the use of such information.

3. What to expect: • From this presentation I hope you: • Obtain a basic understanding of how taxes are calculated. • Understand how capital losses and passive losses impact a client’s tax return. • Can identify common mistakes to avoid. • Learn new tax strategies that will be of value to your clients. • Understand the importance for the tax preparer, advisor(s), and client to work together to minimize tax liability. • Gain a working knowledge of the tax return, knowledge that allows you to provide advice to your clients and will set you apart from other advisors. • Are able to determine if your client is not getting the tax guidance they need; this knowledge may allow you to refer that client to a CPA from whom you may receive referrals.

4. The majority of this presentation is based on tax laws that were in effect for tax year 2017.

5. Who is advising the client on tax strategies?

6. Who is advising the client on tax strategies? • Many clients are not receiving tax guidance or tax strategies. • The primary reason is a lack of understanding of what each advisor does. • Most financial advisors think tax preparers are providing tax advice.

7. Who is advising the client on tax strategies? • In most cases tax preparers do not have all of the necessary information to provide tax strategies. • Tax preparers believe, if there is a need for tax strategies, the client or one of their advisors will bring that need to their attention.

8. Who is advising the client on tax strategies? • This “gap” can be partially bridged if financial advisors have an understanding of their clients’ tax situation and if tax preparers have an understanding of their clients’ financial situation. • I believe the gap can be further bridged if the tax preparer, financial advisor and other advisors are able and willing to communicate on a regular basis with and on behalf of the client.

9. Who is advising the client on tax strategies? • Due to the volume of tax returns they prepare, many tax preparers are unable to be proactive in providing tax advice/strategies. • At a minimum, every financial advisor should obtain a copy of their clients’ tax returns and business returns (if applicable) every year.

10. How taxes are calculated on a 1040 tax return:

11. How taxes are calculated on a 1040 tax return: • Taxes are calculated based on the amount of ordinary income, qualified dividends, long-term capital gains and deductions the taxpayer reports on their tax return. • Ordinary income is best defined as income other than long-term capital gains (LTCG) and qualified dividends (QD).

12. How taxes are calculated on a 1040 tax return: • Ordinary income is subject to the tax rates most are familiar with; for tax year 2017, these were 10%,15%, 25%, 28% 33%, 35% and 39.6%. • LTCG & QD are subject to different tax rates; these are 0%, 15% and capped at 20%. The tax rate that applies to LTCG & QD is based on the overall income a taxpayer is reporting.

13. How taxes are calculated on a 1040 tax return: • Depreciation recapture is taxed differently than ordinary income and LTCG/QD. • Recapture is recognized when an asset that has been depreciated is sold for a taxable gain. • Recapture can be subject to the lower rates but is capped at 25%.

14. How taxes are calculated on a 1040 tax return: • Our tax system is progressive, which means that the tax rate increases as the taxable income increases. Income can be subject to multiple tax rates, based on the filing category of the taxpayer and the amount of taxable income: • It is not uncommon for taxpayers to have their taxable income taxed at the 10%, 15%, 25%, etc. rates. • With LTCG and QD income, the 0% rate could apply as well.

15. HOW TAXES ARE CALCULATED ON A 1040 TAX RETURN: • Ordinary taxable income brackets for Married Filing Joint (MFJ): • 10% up to 18,650 • 15% from 18,651 to 75,900 • 25% from 75,901 to 153,100 • 28% from 153,101 to 233,350 • 33% from 233,351 to 416,700 • 35% from 416,701 to 470,000 • 39.6% above 470,001

16. How taxes are calculated on a 1040 tax return: • A taxpayer’s income could be subject to 11 different tax rates, not including Alternative Minimum Tax (AMT) rates. • It is a common belief that taxes are calculated in a manner that always favors the government; however, when it comes to a tax return with LTCG and/or QD, the calculation actually favors the taxpayer.

17. How taxes are calculated on a 1040 tax return: • For tax year 2017, LTCG and QD are taxable once a taxpayer’s taxable income enters the 25% bracket. For MFJ filers, this occurs when taxable income is above 75,900; for single filers it is when taxable income is above 37,950. • Note: the 2018 tax law makes a change to when LTCG and QD become taxable. It is no longer tied to a tax bracket; however, the tax benefits be similar to the prior tax law.

18. How taxes are calculated on a 1040 tax return: • When reporting LTCG and/or QD the tax calculation begins by: • Separating ordinary income from LTCG and/or QD income. • Then, all itemized or standard deductions (and what were formerly personal exemptions) are first used to reduce the taxable portion of ordinary income.

19. How taxes are calculated on a 1040 tax return: • This approach results in a reduced amount of ordinary income that is subject to normal tax rates (10%, 15%, 25%, etc.) and more LTCG and QD income that is subject to the lower tax rates (0%, 15%, 20%). • Here is an example of a retired married couple in their 60’s:

20. How taxes are calculated on a 1040 tax return: • Adjusted Gross Income (AGI) of 97k • Of this, 35k is LTCG & QD and 62k is ordinary income (pension, SSA, interest income). • Deductions total 39k, resulting in taxable income of 58k (97k - 39k). • The 58k of taxable income results in federal taxes of 2.5k, an effective tax rate of 4.3%. • The reason for the low rate is because the tax code allows the 39k of deductions to offset the 62k of ordinary income first.

21. How taxes are calculated on a 1040 tax return: • This results in 23k of ordinary income that is subject to normal tax rates (in this case both the 10% and 15%) and 35k that is subject to the capital gain rates. • Because their 2017 taxable income of 58k was under the 25% tax rate, the 35k of LTCG and QD income is taxed at 0%.

22. How taxes are calculated on a 1040 tax return • This client could have received an additional 15k in LTCG and/or QD income and their federal taxes would have remained at 2.5k. • If all of their 97k was derived from ordinary income, their taxes would have been over 7.7k. (three times as much)

23. HOW TAXES ARE CALCULATED ON A 1040 TAX RETURN: • It’s important to note that the tax treatment was not because the client is retired. Had the 62k been derived from W2 wages, self-employed income, rental income, etc. (instead of pension and SSA) the taxes of 2.5k would have been the same. • For tax calculation purposes, the tax code does not differentiate between types of ordinary income. Ordinary income is ordinary income regardless of the source.

24. HOW TAXES ARE CALCULATED ON A 1040 TAX RETURN: • Taxable income of 175,000 from ordinary income sources only for MFJ would be taxed as follows: • The first 18,650 would be subject to the 10% bracket – tax of 1,865. • Income between 18,651 and 75,900 (57,250) is subject to 15% bracket – tax of 8,587 • Income between 75,901 and 153,100 (77,200) is subject to 25% bracket –tax of 19,300 • Income between 175,000 and 153,101 (21,900) is subject to 28% bracket – tax of 6,132. • Total tax is 35,884 (1,865+8,587+19,300+6,132)

25. How taxes are calculated on a 1040 tax return: • The impact ordinary, LTCG, & QD income has on state taxes can vary depending upon where the client resides. • Virginia does not distinguish between ordinary, LTCG, and QD; all income, regardless of source, is taxed the same.

26. How taxes are calculated on a 1040 tax return: • A client’s tax return does not always correlate to their overall net worth. In this case: • Client’s estate value is 4.5 million. • 1.5 million is real estate and 3 million is investments. • Of the 3 million, 2 million is qualified and 1 million is non-qualified.

27. HOW TAXES ARE CALCULATED ON A 1040 TAX RETURN: • When SSA benefits are taxable: • For MFJ, 50% of SSA benefits begin being taxable when all sources of income, plus ½ of SSA, is between 32,000 to 44,000. • For every dollar of income earned between 32k up to 44k, 50% of SSA benefits are taxable. 2k of QD, LTCG, IRA distributions, or W2, etc. will cause 1k (50% of 2k) of SSA benefits to be taxable)

28. HOW TAXES ARE CALCULATED ON A 1040 TAX RETURN: • For MFJ, 85% of SSA benefits are taxable when all sources of income, plus ½ of SSA, is above 44,000. • Every dollar of income that exceeds 44k will cause 85% of SSA benefits to be taxable. 2k of QD, LTCG, IRA distributions or W2, etc. will cause 1.7k (85% of 2k) of SSA benefits to be taxable. This will continue until 85% of SSA benefits are taxable.

29. HOW TAXES ARE CALCULATED ON A 1040 TAX RETURN: • Please note that just because SSA income is taxable does not mean it will generate taxes. As already discussed, the type of reported income and the amount of deductions determine taxes. • Higher amounts of ordinary income and lower deductions will likely generate more taxes. • The tax implications of income from QD or LTCG with higher deductions could be minimal.

30. How taxes are calculated on a 1040 tax return: • Take away: • The 2018 tax law changes when LTCG and QD become taxable. Tax benefits should be similar. • Know if your clients’ LTCG and QD are taxed at the lower tax rates of 0%, 15%, and 20% and how that may impact your advice. This is especially significant if you are investing near the end of the year and in a MF that is likely to pay out LTCG or if you are planning to sell gains.

31. How taxes are calculated on a 1040 tax return: • Take away continued: • Remember that itemized and standard deductions are used to offset ordinary income first; this results in more LTCG and QD subject to the lower rates. • Lower AGI does not always reflect low net-worth; conversely, higher AGI does not always reflect high net-worth.

32. How taxes are calculated on a 1040 tax return: • Take away continued: • Understand how income from investments, IRA distributions, annuities, etc. could impact the taxation of SSA benefits.

33. Capital losses and how they affect a tax return:

34. Capital losses and how they affect a tax return: • Selling a position to generate a capital loss, with the intent of offsetting a capital gain, can at times, result in no or minimal tax benefit to the client. • If this same client had a capital loss up to the amount of LTCG, their tax liability would have remained at 2.5k. This is because the loss is offsetting a LTCG, which was subject to the 0% bracket.

35. Capital losses and how they affect a tax return: • Short-term capital gains and losses can be used to offset long-term capital gains and losses. • Capital losses from any source (stocks, MF, real estate, sale of businesses, etc.) can be used to offset gains from any source (stocks, MF, real estate, business, etc.) They are not required to be like-kind or from the same source.

36. Capital losses and how they affect a tax return: • Capital losses that exceed capital gains in any tax year are limited to 3k per year. • When capital losses exceed capital gains, they offset ordinary income. • Any losses in excess of 3k are carryforward until they are fully used.

37. Capital losses and how they affect a tax return: • Carryforward capital losses that are not used before the taxpayer passes away are lost; they cannot be transferred to heirs. The surviving spouse can continually use the capital losses until they are used up or they pass away. • Many taxpayers die every year leaving thousands and in some cases tens or hundreds of thousands of losses that will never be used.

38. Capital losses and how they affect a tax return: • Take away: • Knowing whether a client has carryforward losses can be beneficial when providing investment advice; these losses can be used to offset the sale of an asset with significant appreciation or a LTCG from a year-end MF purchase. • See if the client has carryforward capital losses prior to becoming your client.

39. CAPITAL LOSSES AND HOW THEY AFFECT A TAX RETURN: • Take away continued: • If the losses remain limited to 3k, this could provide an opportunity to recognize ordinary income up to 3k from an annuity withdrawal, IRA distribution, interest from saving bonds, etc. Or it can simply be used to reduce the client’s taxes.

40. What are passive losses and how can they affect a client’s return?

41. What are passive losses and how can they affect a client’s return? • A passive loss is a financial loss from any trade or business (other than rental activity) in which the investor is not a material participant. • The most common passive loss is from commercial or residential rental ownership with active participation. The tax code automatically considers rental ownership to be passive unless the owner is a “real estate professional”.

42. What are passive losses and how can they affect a client’s return? • The deduction of rental passive losses is limited to 25k per-year for taxpayers with AGI under 100k. (AGI phase out for married filing separate is different). • For those with AGI between 100k-150k, the rental passive loss deduction is phased out. (The income phaseout has remained the same since 1986 and has not been indexed for inflation). • Taxpayers with AGI above 150k cannot deduct a net rental passive loss; it is carryforward. • Over the years, as wages have increased, more taxpayers have become subject to the phaseout.

43. What are passive losses and how can they affect a client’s return? • When preparing the return, rental passive losses from one property can be used to offset rental passive gains from another property. • In the year a property is sold, all carryforward rental passive losses associated with that property are deductible with no limitation. This can result in a net operating loss (NOL). • Rental passive losses from unsold properties can be used to offset gains from properties that were sold.

44. What are passive losses and how can they affect a client’s return? • For example: • Taxpayer had six residential seasonal rental properties in the Outer Banks and sold four in one tax year. • For the majority of the years he owned the properties, his AGI was above 150k. His annual earned income was around 250k.

45. What are passive losses and how can they affect a client’s return? • This resulted in carrying forward 1.2 million of passive losses that had not been deducted. • Of this, 450k were carryforward losses on the two properties that were not sold.

46. What are passive losses and how can they affect a client’s return? • The four properties were sold for a combined gain of 1.6 million. Of this gain, 950k was recapture of depreciation, which is taxed at a maximum of 25%. • The remaining 650k was normal LTCG.

47. What are passive losses and how can they affect a client’s return? • Because the combined gains from the sale of the four properties (1.6 million) was more than the combined passive loss carryforward for all six properties (1.2 million), he was able to use the carryforward losses from the two properties that were not sold to offset the gains on the four properties that were sold.

48. What are passive losses and how can they affect a client’s return? • As with LTCG and/or QD, when the tax calculation favors the taxpayer, the same applies to how passive losses are deducted, specifically in the year the property is sold. • Passive losses offset ordinary income and recapture depreciation first and are used to offset the LTCG from the rental property last.

49. What are passive losses and how can they affect a client’s return? • This approach results in less of the ordinary income and recapture subject to the higher tax rates and more of the LTCG subject to the lower tax rates. • For this client, after applying all of the passive loss carryforwards and itemized deductions, his taxable income was 386k.

50. What are passive losses and how can they affect a client’s return? • The amount of tax generated was 55k or 14% of the 386k taxable income. Some of the gain was actually taxed at 0%. • For this client, all of the carryforward losses were used to offset the gains on the four properties he sold. • When he sells the remaining two properties, the majority of the gains from those properties will be taxable.