Vacation Properties and Income – Part 2

September 14, 2009

Another way for retirees to generate income from a vacation home is to sell it. By using the federal capital gains exclusion in conjunction with the sale of your primary residence, you can potentially realize tax-free income. Here’s how it works. The basic capital gains exclusion rules state that you must have owned and used the home as your primary residence for at least two years out of the five-year period ending on the date of the sale. If you are married, the full $500,000 exclusion ($250,000 for single homeowners) is available as long as one or both of you satisfies the ownership test (two years) and you both satisfy the use test (primary residence).


Vacation Properties and Income – Part 1

September 10, 2009

If you have a vacation home, you’re already aware of the enjoyment it provides and the benefits it can offer at tax time. But you may not be aware of how vacation property can be used to generate income in retirement or how it can play into an estate plan. In fact, vacation properties offer retirees a number of different options in managing their finances and estate.
Vacation property may be used to generate income in several different ways. The first, and most obvious, is renting it. The IRS allows you to deduct mortgage interest on your primary residence and one additional property up to a limit of $1 million in combined mortgage debt for mortgages taken out after 1987. Current tax rules also allow you to rent out a second home for up to 14 days per year without having to report the rent as income. If you rent for more than 14 days, the home is considered investment property, and rent must be reported as income. Converting the property to an investment property, however, allows you to deduct rental expenses, such as insurance and utilities, if you have a net profit on the property (deductions are limited if you report a loss). You can still use an income-producing property for personal use while maintaining your tax advantages — but only for the greater of 14 days or 10 percent of the total days it is rented. Maintenance days do not count as personal-use days, but use by in-laws or other part-owners does, even if rent is charged.


Simple Truths

September 8, 2009

As a financial advising firm, one of the simple truths we have learned is that relationships are the single greatest influence on how people use their money and plan for the future. When people talk about their hopes and dreams, they talk about the people they love. Their future, the life they wish to live, is always full of the people most important to them. They don’t talk first about dollars and cents, Dow averages, or bond yields. They talk about a spouse, a parent, a child. When imagining their financial futures, even those without family often focus on others, such as employees, friends, faith communities, and charities.


Keeping Your Emotions in Check…

September 3, 2009

In times like these, with the economy in a tailspin, and the stock market in the tank, investing requires an extra dose of patience, perseverance and perspective.
It takes patience to ride out the bear market, perseverance to continue to invest even through a difficult economy, and perspective to see the long-term picture and realize that recessions and bear markets are just part of the natural economic cycle. Slumping economies and bear markets of the past have always turned around — and there is no reason to believe that this time will be any different.


Saving for College

August 31, 2009

Saving for College
Another school year is around the corner and your children or grandchildren are that much closer to college. If you haven’t already started to save for their college costs, this may be a good time to talk to your adviser about setting up a tax-sheltered college savings plan.
By planning ahead, you can use a 529 college savings plan to give your children a head start on their college costs. There are two types of 529 plans: college savings plans and prepaid tuition plans.
College savings plans are state sponsored investment accounts that allow participants to contribute regularly. A 529 plan account grows tax-deferred and withdrawals from the plan for qualified educational expenses are exempt from federal income tax. There are no income limits.


Tax-Smart Idea for Managing Your Portfolio #2:

February 23, 2009

Consider Investing in Municipal Bonds

Municipal bonds, or “munis” as they are frequently called, are bonds issued by state or local municipalities to fund public works projects such as new roads, stadiums, bridges or hospitals. A municipal bond can also be issued by legal entities such as a housing authority or a port authority. For this reason, municipals can be an excellent way to invest in the growth and development of your community.

In addition, because the interest earned on municipal bonds is exempt from federal income taxes and may be exempt from state and local taxes (if they are purchased by residents of the issuing municipality), munis have the potential to deliver higher returns on an after-tax basis than similar taxable corporate or government bonds. What this means is that although the interest paid on municipal bonds is typically a lower percentage than is paid on taxable bonds, because it is tax free, it is, in effect, not as low as it appears. A simple calculation known as the “taxable-equivalent yield” can be used when considering an investment in a municipal bond.

For instance, if your income tax rate is 35%, a municipal bond paying 5% interest is actually a better investment than a taxable bond paying interest at 7.7%. Thus, for investors in a high tax bracket, the benefits of using municipal bonds in a fixed-income portfolio can be significant. Municipal bonds are subject to availability and change in price. Subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.

© LPL Financial, created by Standard & Poors

Securities offered through LPL Financial, Member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, a registered investment advisor.


Income that the IRS can’t touch

December 26, 2008

Municipal Bonds

There’s one readily available and legal source of untaxed income that we know of: municipal bonds. These securities are issued by state and local governments, school districts, hospitals and other public agencies to support community projects and services. To permit these worthy endeavors to raise money economically, Uncle Sam exempts the interest that they pay from federal income tax. And state governments usually do the same for bonds issued within their borders.

As a result, these tax-advantaged “munis” only pay about 75%-90% of the interest that you’d earn on a taxable bond of comparable maturity and credit quality. So, depending on your tax bracket, munis actually may give you higher after-tax income. To figure the equivalent taxable yield of a tax-free bond, divide its yield by one minus your tax rate expressed as a decimal. Thus, if your tax bracket for 2006 is 35%, a 5% tax-free yield would be worth 5% divided by 0.65, or 7.69%.

If you live in a high-tax state, this advantage can be even more dramatic. Suppose that you pay an 8% state tax. Because you deduct state tax from your federal income, your effective state tax is 5.20% (8% x .65), and your combined tax rate is 40.20%. So you’d divide that 5% by .598 (1-.402) and get 8.36%. In that case, you’d prefer the 5% muni issued in your state to any comparable taxable bond paying less than 8.36%. The table at the end of this article shows taxable-equivalent yields for each 2006 federal tax bracket. Obviously, the higher your tax bracket, the larger the benefit of tax-advantaged investments.

Types of municipal bonds
According to their issuers and their terms, munis fall into several distinct categories.

General obligation bonds are backed by the full taxing power of the city or state that issues them.

Revenue bonds pay their coupons and repay their principal from the revenues of the projects that they fund, which can be toll bridges, airports or other public facility.

Private activity bonds are issued in support of private projects, such as industrial parks or shopping malls, intended to bring business to the community. Although income from these bonds issued after August 1, 1986, is exempt from income tax, it is hit by the alternative minimum tax when earned by investors subject to the AMT. This threat tends to push the yields of these bonds up a bit, boosting their attraction for investors not affected by the AMT.

Zero-coupon municipal bonds are sold at a large discount from their face value and pay no current interest. The investor instead receives the full face value at maturity, with all the gain tax free.

Prerefunded bonds. With the relatively low interest rates of the last few years, some municipalities have issued bonds to pay for the redemption of older, higher-yielding bonds on their call date. Until that time the money is usually parked in U.S. Treasury securities. As a result, the prerefunded older munis carry an extra measure of safety.

Risk management
As with other fixed-income securities, munis are subject to two distinct types of risk:
Interest rate risk refers to the fact that a bond loses value in the secondary market when interest rates rise. Nobody will pay full price for a 5% bond when new bonds are available that pay 6%. So, if you need to sell a bond in that situation, you’ll have to accept a price that will give the buyer a competitive yield.

On the other hand, if interest rates fall, the value of your bonds will rise. Don’t count your chickens, though. Most munis carry call provisions allowing the issuer to redeem the bonds early at a specified date, usually with the payment of a call premium. Note that any loss that you take on the sale of a muni may be used to offset capital gains plus up to $3,000 of ordinary income. Any gain, however, may be subject to ordinary income tax (not the reduced capital gains rate).

Of course, if you hold a bond to maturity, interest rate risk is not an issue. Credit risk refers to the possibility that the issuer will default on the timely payment of interest and/or principal. Albeit a rare occurrence, we had the 1994 example of Orange County, California, to impress this possibility upon us. Naturally, lower-rated issues carry higher yields, but of late the spread between high-quality and junk bonds has been little more than 1%. So it’s hardly worth accepting the extra risk for the marginal boost in income.

As mentioned above, pre-refunding can enhance the safety of a bond. More common, however, is the use of insurance to upgrade an issue’s quality. Issuers purchase private insurance that guarantees payment of interest and principal in the event of a default. Bonds thus covered automatically gain an S&P rating of AAA.

Another way to protect a tax-advantaged portfolio is diversification. Bonds of different types, from widespread issuers, and of varying maturities cushion the effect of trouble in any one sector. Because most munis are issued in multiples of $5,000 or $25,000, such diversification is not possible for most individual investors. For a tax-advantaged portfolio of less than $500,000 or so, experts recommend investing in either tax-advantaged money managers or unit investment trusts.

If tax-advantaged income at the yields available currently fits your financial needs, we’re ready to help you build a working portfolio.

Taxable equivalent yields
Equivalent Taxable Yield* by Tax Bracket in 2006
Muni Yield 10% 15% 25% 28% 33% 35%
3.00% 3.33% 3.53% 4.00% 4.17% 4.48% 4.62%
3.50% 3.89% 4.12% 4.67% 4.86% 5.22% 5.38%
4.00% 4.44% 4.71% 5.33% 5.56% 5.97% 6.15%
4.50% 5.00% 5.29% 6.00% 6.25% 6.72% 6.92%
5.00% 5.56% 5.88% 6.67% 6.94% 7.46% 7.69%
5.50% 6.11% 6.47% 7.33% 7.64% 8.21% 8.46%
6.00% 6.67% 7.06% 8.00% 8.33% 8.96% 9.23%
*Federal tax only. If an investor is subject to state and local income taxes, equivalent yields would be higher.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Securities offered through LPL Financial, Member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, a registered investment advisor.

© 2006 M.A. Co. All rights reserved.
Any developments occurring after January 31, 2006, are not reflected in this article.