TAX REFORM PROPOSALS – DIVIDEND AND CAPITAL GAINS.

 

Here are my thoughts on reform of the tax treatment of dividends and capital gains.
 
There should no longer be a special lower tax rate on “qualified” dividends and long-term capital gain.  ALL income would be taxed at “ordinary income” rates.  Corporations should be allowed to claim a “dividends paid” deduction on the corporate return, reducing the corporation’s taxable income, so there would no longer be a double-taxation of dividends. 
 
As for long-term capital gain, it would be “déjà vu all over again”.  Back when I first started out in “the business” in the early 1970s Schedule D allowed for a 50% deduction for net long-term capital gain – only half of such gains were included in taxable income reported on the Form 1040.  If the combination of net short-term and net long-term capital transactions on Schedule D showed a gain you would deduct 50% of the smaller of the total net gain or the net long-term gain to come up with the amount to carryforward to the Form 1040.  I would return to this policy and, instead of taxing net long-term gain at a lower rate, provide for a 50% deduction claimed on Part 2 of the Schedule D.  So, if your tax rate was 10% the actual tax you would pay on net long-term capital gains would be 5%, or 12% if you were in the 24% bracket.   
 
I have always had issues with limiting the current deduction for net capital losses to $3,000.  Business losses are allowed a full current deduction, so why not investment losses.  However, I expect I would keep this limitation, but I would index the $3,000 for inflation.
 
What I would do is allow for excess net capital losses to be carried back at least one and perhaps three years.  Currently if you have $10,000 in net capital losses in 2022 you can deduct $3,000 against other income on the 2022 Form 1040 and carry forward the remaining $7,000 to apply against 2023 gains, again subject to the annual $3,000 limit.  If the $7,000 is not all used up in 2023 the excess is carried forward to 2024, and so on.  But the excess loss cannot be carried back.  I would allow taxpayers the option to first carry back the $7,000 to 2021, or 2019, to apply against any net gains reported on the 2021, or 2019, Form 1040.
 
I first proposed this idea in a letter to George W Bush back in 2002 when the initial Bush tax cuts were being formulated.  During the late 1990s and into 2000, when the stock market was flourishing, many taxpayers realized, and were taxed on, large capital gains, including excessive capital gain distributions from mutual funds. In most cases these capital gains were reinvested in the market and in additional mutual fund shares.  In 2001 and 2002 the bear market provided these same investors with substantial capital losses. It seemed to me at the time only fair that they be allowed to carry back the losses to apply against the earlier gains of the bull market and get a refund of the taxes paid on these gains.
 
Back then I had 1040 clients, a married couple, who had $200,000+ in net capital gains, much of it short-term, in one calendar year, followed the next calendar year by $200,000+ in losses.  So, in reality they did not have any net income.  However, the $200,000 was taxed, most at ordinary income rates, when earned, but only $3,000 in losses was deducted per year in subsequent years.  Unless the taxpayers had another huge gain in a subsequent year, it would take forever to fully use up the $200,000+ in net capital losses.  The client is still carrying forward the remnants of this $200,000+ loss.           
 
As an aside – here is the response I received to my letter to Dubya –
 
"Dear Mr. Flach:
 
On behalf of President Bush, I thank you for your letter. The President appreciates hearing your view and concerns.
 
President Bust remains confident in the faith and resolve of our Nation, and he is confronting our country's challenges with focus, clarity, and courage. As the President has said, this is a time of great consequence, and he is working for a prosperity that is broadly shared, strengthening domestic programs vital to our country, and answering every danger that threatens the American people.
 
To accomplish these goals, President Bush welcomes suggestions from all Americans. Thank you again for sharing your ideas.
 
Sincerely,
Desiree Thompson
Special Assistant to the President and Director of Presidential Correspondence"  
 
So, what do you think?
 
TTFN

 

WHAT TO DO WHEN YOU MAKE A GIFT OF STOCK

Here is some important advice for parents, grandparents or others who give their children, grandchildren or others gifts of stock shares – advice that will save the recipient of the gift, or more likely their tax professional, agita and aggravation when they sell the stock 10, 20, 30 years down the road – tell the recipient, in writing, when you purchased the shares and what you paid for them.

You should also tell the recipient, in writing, the “fair market value” of the shares at the time of the gift. 

When reporting the cost basis of an investment you sell that was received as a gift you need to know the cost basis of the person who made the gift, the fair market value of the investments on the day the gift was given, and when the person making the gift purchased the investments.  Generally, the “holding period” for determining long or short term begins on the date the person making the gift purchased the investment.

You should give the recipient of the stock, or his or her parents if a minor child, a copy of the “confirm” or a highlighted entry in a brokerage account statement, that shows the date of purchase and purchase price and a note that indicates the date of the gift and the stock’s value on that date – easily acquired via an online price quote.

In some cases, the gifted stock is purchased currently and given to the recipient.  Grandpa buys 75 shares of stock for his grandson on Monday and gives the stock to him on Wednesday.  But this is not always true.  The father of one of my clients had invested in PSEG regularly over the years, and participated in the company’s dividend reinvestment program.  Years after his initial investment he gifted 75 shares of his PSEG stock to his adult son.  And the son sold some of the shares 26 years later.

If you made a gift of stock in the past you should gather the information and give it to the recipient now.  You can use Big Charts to get a historical price quote for the fair market value on the date of the gift.   

TTFN

JUST SAY NO!

Suggesting an end to the step-up in basis for inherited investments, which has been suggested often over the years, is clear proof that those who write the tax laws have absolutely no clue about the actual practical application of what they write.

Ending the step-up would be a nightmare for taxpayers and tax preparers. 

Most of my clients have no idea of the cost of investments they purchased, let alone the cost of investments they inherit.  Or how the deceased acquired the investments that are inherited (purchase, gift, inheritance, employee stock ownership program, etc.).  And there is the issue of dividend reinvestment to consider.  

Per T.C. Memo 2003-259, if a taxpayer cannot provide proof of the cost basis of a stock or other investment sold it will be considered to have a "0" cost basis.  So, if the taxpayer cannot properly identify the cost basis the entire gross proceeds will be fully taxable.   

It could be OK if the deceased acquired all investments by purchase only and used the same brokerage for all investment purchases because the deceased’s broker could have all the cost basis information.  Or if the deceased actually kept meticulous records of all investment acquisitions.  But these situations would be the exceptions and not the rule.

And if there is no step-up in basis then the estate tax should be based on the original cost of investments and not the market value at date of death.

It seems I may be retiring at just the right time.  

TTFN

THE VALUE OF A TAX DEDUCTION - MORE THAN YOU MAY THINK

An interesting development worth discussing.  This is something that should be considered when doing year-end tax planning in a year you had qualifying dividend and capital gain income.

A client had substantial capital gains for 2018 which were taxable at the lower capital gains rates.  A portion of the capital gains were taxed at 0% while most was taxed at 15%.  The client’s “ordinary” income was taxed at the 12% marginal tax rate.  If we disregard the capital gain income – if all his income had been taxed as ordinary income - the client would have been in the 24% marginal bracket.

After I had done an initial write up and tax calculation the client told me about an additional $350 non-cash contribution to the Salvation Army he had failed to include when sending me his stuff.

This additional $350 reduced his net taxable income and therefore reduced his “ordinary” income tax by $42 - $350 x 12%. 

But the $350 reduction in net taxable income also allowed an additional $350 of his capital gains to be eligible for the 0% rate, so $350 less in capital gain income was taxed at 15%.  He reduced his tax liability by another $52.50 - $350 x 15%. 

The bottom line - the additional $350 deduction saved him $94.50 – or 27% - in federal income tax.

As we can see, because of the different rates for different types of income the savings from a tax deduction can be more than the ordinary marginal tax rate.  In the above example the savings was more than twice this rate.

This example involved a “below the line” tax deduction, the “line” being AGI.  Deductions allowed “above the line” can generate even more savings by reducing the amount of other deductions or credits that are phased-out based on AGI and reducing the amount of taxable Social Security or Railroad Retirement benefits.

This is something that should be considered when doing year-end tax planning in a year you had qualifying dividend and capital gain income.

TTFN

STUFF

ü  Despite being in “the business” for 45 years, I usually learn one or two new things from the various monthly and quarterly print publications of the National Association of Tax Professionals.  The latest issue of TAXPRO MONTHLY provided the following –

“Did you know that ‘CP’ stands for ‘Computer Paragraph’?  So CP2000 stands for Computer Paragraph 2000, an automated letter that is triggered by discrepancies on the tax return.” 

The form letter that you receive from the IRS indicating something may be wrong or missing on, or requesting additional information for, your 1040 (or 1040A) is identified by numbers, or numbers and letters, preceded by “CP”.  I actually never, until now, actually knew what the “CP” stood for.

The article in this issue about responding to a CP2000 reminded me of the importance of properly dealing with IRS and state tax agency letters, notices and statements.  If you receive a form letter or notice from the IRS or your state DO NOT IGNORE IT – the issue will not just go away!  And DO NOT PUT IT ASIDE TO DEAL WITH IN THE FUTURE.  Review it immediately.  If the return in question was prepared by a professional tax preparer SEND THE LETTER OR NOTICE TO YOUR TAX PREPARER IMMEDIATELY!

In my experience at least 2/3, if not 3/4, of all such notices are wrong – more with state notices than federal ones – but they definitely do need to be responded to promptly.

And, while the IRS or state wants you to respond promptly, do not expect a prompt response to your reply from the government.  In about 45 days after you rely to an IRS notice or letter you will receive a form letter from “Sam” saying that they need an additional 45 days to properly review and process your response.  45 days later you will receive a second letter telling you they need another 45 days.  When dealing with any government agency you need patience.

ü  As a point of information, all my writings about federal tax planning and preparation, here at TWTP or in any of my electronic or print publications, applies to a taxpayer who lives in a “non-community property state”, which most states are. 

The specific rules and regulations that apply to community property states are, to be honest, somewhat FU-ed.  In my 45 years as a paid preparer I have never had to deal with community property state issues, and certainly never will going forward.  So I have never had the need, or desire, to research community property state rules and regulations.

FYI, the current community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.  Alaska is an opt-in community property state that gives both parties the option to make their property community property.  So if you live in one of these states you may need to check on some of what I discuss here at TWTP with a local tax professional.

ü  A recent discussion with a client and friend had me do some research to verify what I had believed to be true regarding the tax basis of jointly-held investments for a surviving spouse.

What I had believed to be true was indeed true –

If investments are jointly owned by a married couple in a non-community property state (important) – stock, bonds, and mutual fund shares held in a joint brokerage account, or real estate jointly owned - and one spouse passes, the deceased spouse’s half of the investments will receive an automatic “step-up” in basis to the federal estate tax value, even if no federal estate tax return is filed or no estate tax is due.  This is generally the market value of the investment on the date of death of the deceased spouse, but could also be the market value 6 months from the date of death if this alternate valuation is elected on a federal return.    

My discussion with the friend and client, a stock broker, also verified what I suspected.  If a beneficiary sells a stock that he or she inherited, the cost basis reported on the Form 1099B issued by the brokerage, whether or not the sale involves a “covered” investment, will not necessarily report the correct tax basis of the investment – the “date of death” value – even if the deceased and the beneficiary had the same broker.  It may – but only if the individual broker has made the proper adjustment to the cost basis in the internal brokerage reporting system.

So it is very important for your tax professional, or you if you are self-preparing, to independently verify the correct cost basis for inherited investments sold to determine if any adjustments are needed to the Form 1099B numbers.

TTFN

 

 

 

 

 

 

 

 

 

 

 

 

 

TRAPPED BY OUR CAPITAL GAINS ARE WE

We all know, or at least many of us know, that long term capital gains (gain on the sale of investments held more than one year and capital gain distributions from mutual funds) and qualified dividends are taxed separately at special lower rates.  Those in the 10% and 15% brackets pay 0% tax on this income, those in the 25% - 35% brackets pay 15%, and those in the top 39.6% bracket pay 20%.  And that these applies to both the “regular” income tax and the dreaded Alternative Minimum Tax (ATM). Right?

 

Well it ain’t necessarily so {wow! 2 Broadway musical lyric references in one post!}.

Long-term capital gains and qualified dividends are reported as taxable income on Page 1 of the Form 1040 and are included in Adjusted Gross Income (AGI).  There are a multitude of deductions and credits that are reduced, phased out, or disallowed based on one’s AGI.  These include:

•  deductible traditional and spousal IRA contributions,

•  the ability to contribute to a ROTH IRA,

•  student loan interest,

•  the deduction for tuition and fees (if extended)

•  medical and dental expenses,

•  charitable contributions,

•  casualty and theft losses,

•  miscellaneous itemized deductions,

•  total Itemized Deductions,

•  the deduction for personal exemptions,

•  the Credit for Child and Dependent Care Expenses,

•  the Credit for the Elderly or Disabled,

•  the American Opportunity and Lifetime Learning education credits,

•  the Retirement Savings Contributions Credit,

•  the Child Tax Credit,

•  the Adoption Credit,

•  the Earned Income Credit, and

•  Coverdell Education Savings Account contributions.      

And as AGI increases so does the taxable portion of Social Security and Railroad Retirement benefits, and the deductible loss from rental real estate is reduced or phased out.

In the case of Social Security and Railroad Retirement benefits, an additional $1.00 of AGI can increase taxable benefits by as much as 85 cents.  So capital gain and qualified dividend income for a taxpayer in the 25% bracket could be effectively taxed at 21.25%, as an additional $1.000 in such income could increase taxable income by $850.

And even $10 in such income could cause a taxpayer to lose a $2,000 deduction for tuition and fees, if extended, and cost $500 in taxes in the 25% bracket.

Even though long-term capital gain and qualified dividend income is taxed separately at the special rates under the dreaded AMT, since this income increases AGI it also increases Alternative Minimum Taxable Income (AMTI), and could reduce the amount of the allowable AMT exemption.  $1,000 of such income could increase income subject to the 26% AMT tax by $250 and cost an additional $65.00.

And we all, or many of us, know that only $3,000 in net capital losses can be currently deducted on the Form 1040.  Any excess losses are carried forward to subsequent years.  If the total net loss for 2015 was $10,000, $3,000 is deducted in 2015 and $7,000 is carried forward to 2016.  So the loss is not lost.

 

But this is not the case on NJ or PA state income tax returns (I don’t know of any other states offhand).  These states do not allow any carryforward of capital losses.  So the $7,000 mentioned above is truly lost when it comes to state income tax.  Actually the entire $10,000 in losses are lost – as these states have a “gross” income tax system and do not allow capital losses from the sale of investments to reduce income in other categories.  

 

I am not saying to avoid long-term capital gains or losses.  The first criteria for evaluating any transaction, strategy, or technique you are considering should always be financial.  Taxes are second.  Never let the tax tail wag the economic dog.  Sell a stock or mutual fund shares for the best possible price.  By postponing a sale to meet the long-term criteria or to avoid having to report the income or losses on your tax return the price of the investment could drop and give you a smaller profit or greater loss.

Just be mindful of what I have discussed above, be aware of the true cost of your capital transactions, and consider increasing estimated tax payments or withholding if appropriate.  And consider harvesting losses to offset gains or engaging in a “wash sale” of investments that would generate a gain to offset losses at year end. 

It would be a good idea to discuss actual and planned investment activity with your tax professional periodically during the year, and especially at year end. 

THE FINAL WORD –

I am sorry – I cannot resist.

Speaking of it ain’t necessarily so.  The things that you're liable to hear from Donald Trump, it ain't necessarily so.

TTFN

A YEAR-END TAX PLANNING TIP

Last winter I talked about “Taking Advantage of the 0% Tax Rate” here at TWTP.  As you are working on your year-end tax plan what I talked about then still applies – so I recommend that you re-read this post.

FYI, the 2015 tax rates are -

Tax Rate	Single	Married Filing        Joint	Married Filing    Separate	Head of    Household
10%	Up to $9,225	Up to $18,450	Up to $9,225	Up to $13,150
15%	$9,226–$37,450	$18,451–$74,900	$9,226–$37,450	$13,151– $50,200
25%	$37,451–$90,750	$74,901–$151,200	$37,451–$75,600	$50,201–$129,600
28%	$90,751–$189,300	$151,201–$230,450	$75,601–$115,225	$129,601–$209,850
33%	$189,301–$411,500	$230,451–$411,500	$115,226–$205,750	$209,851–$411,500
35%	$411,501–$413,200	$411,501–$464,850	$205,751–$232,425	$411,501–$439,000
39.6%	Over $413,200	Over $464,850	Over $232,425	Over $439,000

For lots of other year-end tax planning advice and information I suggest you get my “2015 Year-End Tax Planning Guide” – sent to you as a pdf email attachment for only $3.00!

TAKING ADVANTAGE OF THE 0% TAX RATE

In my MainStreet.com article “2014 Year-End Tax Planning Strategies to Ensure a Smooth Filing” I suggest -

“If you will fall within the 10% or 15% brackets you may want to generate additional long-term capital gains to take full advantage of the 0% federal rate.”

Let me elaborate on that advice.

First - yes, that is a “zero percent” tax rate - $1,000.00 taxed at a “0”% tax rate is $0.00 in tax!

The Jobs and Growth Tax Relief Reconciliation Act of 2003 originally reduced the tax rates on long-term capital gains, including capital gain distributions, and “qualified” dividends to 5% and 15%. It called for a 0% tax rate on such income for those in the 10% and 15% brackets for 2008 only. The Tax Increase Prevention and Reconciliation Act of 2005 extended the lower capital gain and dividend tax rates, including the 0% rate, through tax year 2010.  The American Taxpayer Relief Act of 2012 made the lower capital gains rates permanent, and added a new 20% rate for those in the new 39.6% bracket.    

The 0% tax rate applies to Adjusted Net Capital Gains (ANCG), which is –

 

* net long-term capital gains (property held more than one year) less net short-term capital losses (property held one year or less), whether from transactions by the taxpayer himself/herself or passed through to the taxpayer on a Form K-1,

* capital gain distributions from mutual funds, and

* “qualified” dividends.

Net long-term capital gains do not include gains from collectibles, taxed at ordinary income rates up to a maximum of 28%, and “Section 1250” depreciation recapture, taxed at ordinary income rates up to a maximum of 25%.

While ANCG is taxed separately at the special capital gain tax rate for both “regular” income tax and the dreaded Alternative Minimum Tax (AMT), it is important to remember that it is included in Adjusted Gross Income (AGI) as well as Alternative Minimum Taxable Income (AMTI), and can therefore impact items of income, deduction and credit that are affected by AGI as well as cause you to become a victim of the dreaded Alternative Minimum Tax (AMT). 

So in reality income separately taxed at a 0% tax rate may actually increase your tax liability.  And $1,000 taxed at a 0% tax rate may not be $0.00 in additional tax.

For 2014 the 15% tax bracket ends at $36,900 for Single filers and married couples filing separately, $49,400 for Head of Household, and $73,800 for joint filers. If your net taxable income less ANCG is less than the above amount that applies to your filing status you will benefit from the 0% tax rate.

Let us assume that you are single and your net taxable income is $35,000. All of the ANCG income included in the $35,000 will be tax-free on the federal level.  

But what if your net taxable income is $38,000 and your ANCG is $5,000.  The first $1,100 would be tax-free (taxed at 0%) and the remaining $3,900 would be taxed at 15%.

When you prepare your “preliminary” 2014 tax return and add up realized and “paper” capital gains and losses to date as part of the year-end planning process, make a note of your anticipated net taxable income and Adjusted Net Capital Gains.  If have ANCG, and you are “over the top” and within the 25% tax bracket, during the last weeks of 2014 attempt to reduce income and increase deductions to bring you within the 15% bracket, so at least some of your ANCG will be taxed at the 0% rate.

If your projected net taxable income puts you within the 15% bracket, and you have “paper” long-term capital gains in your investment portfolio, consider selling stock or mutual fund shares to generate additional long-term gain to maximize your benefit from the 0% tax rate.    

You can sell the stock or fund shares on Monday and turn around and buy them back on Wednesday. The “wash sale” rules only apply to the sale of stock or mutual fund shares that results in a loss - it does not apply if the sale results in a gain.

Before deciding to sell anything you must first consider how the additional income will impact income, deductions, and credits that are affected by increased AGI, and how it will affect your eligibility for, or the calculation of, the dreaded AMT.

 

And remember – while the additional income will be tax free on the federal return you will be paying state and local income tax on the gains.

 

You should discuss this strategy when meeting with your tax professional to map out year-end tax moves.

Any questions?

TTFN  

TAX EFFICIENT INVESTING

You have several options available for investing your current, retirement, college, and health savings.  It is important to understand the tax aspects of each option, and the tax treatment of the various types of investment accounts – currently taxable, tax-deferred, and tax-exempt - to maximize your “after-tax” earnings from your investments.

DOMESTIC STOCKS

Investment in shares of stock, both domestic and foreign, can generate qualified dividends while held and, if held for more than a year, long-term capital gains when sold.  Qualified dividends and long-term capital gains are taxed at a special lower rate, from 0% (no federal income tax) to 20%, depending on your level of overall net taxable income.  Short-term capital gains (from the sale of stock held for one year or less) are taxed at ordinary income rates, from 10% to 39.6%.

Qualified dividends and long-term capital gains are also taxed at the special lower rate under the dreaded Alternative Minimum Tax (AMT).  However this type of income increases your Alternative Minimum Taxable Income (AMTI) and may cause you to become a victim of AMT and/or reduce your AMT exemption.

And, depending on your level of Adjusted Gross Income (AGI), all dividends and capital gains may be subject to the 3.8% Net Investment Income Tax.

Distributions from tax-deferred accounts, retirement accounts like a traditional IRA or 401(k) and the various self-employed retirement accounts, are taxed at ordinary income rates regardless of the source of the income within the account - so qualified dividends and long-term capital gains earned within a tax-deferred retirement account are taxed at ordinary income rates when the money is withdrawn from the account.

While taxable distributions from a tax-deferred account will increase AMTI, these distributions are not subject to the Net Investment Income Tax.

Stock investments that will generate qualified dividends and long-term capital gains are taxed less if held in currently taxable accounts.

If you, or your broker, are more of a day trader, and invest in some stocks for quick turn-over short-term gains, these stocks could ultimately generate more net after-tax income if held in tax-deferred accounts. 

Regardless of where held the gains will be taxed at ordinary income rates, but holding these investments in retirement accounts will defer the taxation of gains to the future, in future dollars, when distributions are made after retirement (and when your marginal tax rate, or all tax rates, could be less than they are now).  And holding them in deferred accounts will allow for greater eventual growth as a result of the tax deferral.

I am not telling you not to invest tax-deferred funds in stocks that generate qualified dividends and long-term capital gains.  You obviously want to earn as much as possible within a tax-deferred account.  Even though you may lose the benefit of the lower tax rate, you may make up for this by the increased tax-deferred accumulation of income that will ultimately be taxed in the future in future dollars.

What I am saying is that when considering how to invest funds in currently taxable accounts it is more “tax efficient” to choose investments that will generate income taxed at the lower capital gain rates.

INTERNATIONAL STOCK

While the same considerations I discussed under domestic stocks apply to international, or foreign, stock (the stock of a company organized and located outside of the United States), the dividends from international stock will often have foreign tax withheld. 

Foreign tax withheld from dividends generated by currently taxed investments can be taken as a credit - often a 100% dollar for dollar credit against current income tax liability.  Unused credits can be carried forward to be used in future years.

While foreign tax withheld from dividends generated by investments held in a tax-deferred retirement account will reduce the income that is eventually taxed, you do not get the benefit of the tax credit.

You should hold investments in international stock in currently taxable accounts.

TAXABLE BONDS

Bonds pay interest.  Interest is always taxable at ordinary income rates.

Interest on bonds and other direct obligations of the US Government (such as savings bonds and Treasury bonds and notes), while fully taxed at ordinary rates on the 1040, are exempt from state income tax.  

Taxable bonds are a good investment for tax-deferred retirement accounts.

TAX-EXEMPT BONDS

The interest from municipal bonds (issued by the 50 states and the District of Columbia, and the bonds of US possessions like Guam, Puerto Rico and the Virgin Islands) are exempt from the “regular” federal income tax, and the state income tax of a “resident” state (interest from bonds issued by the state of NJ or a NJ municipality, and US possessions, are exempt from NJ state income tax).  Interest from certain “private activity” municipal bonds are taxable under the dreaded AMT.

You should never purchase tax-exempt bonds in a tax-deferred account.

Distributions from a tax-deferred retirement account are subject to federal income tax at ordinary income rates regardless of the source of the income within the account - so interest on tax-exempt municipal bonds earned within a tax-deferred retirement account are taxed at ordinary income rates when the money is withdrawn from the account.

REAL ESTATE INVESTMENT TRUSTS

INVESTOPEDIA tells us that a Real Estate Investment Trust, or REIT, is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages.

Generally the dividend payments issued by a REIT are taxed at ordinary income rates.

REITs should be held in tax deferred accounts.

LIMITED PARTNERSHIPS

My personal, albeit selfish, advice is never invest in limited partnerships in a currently taxable account.

Long-time readers of TWTP know that I hate K-1s from limited partnership investments.  Properly reporting all the items from the K-1, including those buried in attached statements, on the taxpayer’s Form 1040, and keeping track of suspensions, carry forwards and tax basis, causes considerable pain in various parts of the anatomy of a tax preparer.  And the additional tax preparation costs that result can be more than, or at least take a large bite out of, any eventual tax and financial benefits from the investment.  I truly believe that a carefully researched mutual fund will provide the same potential tax and financial benefit as any limited partnership investment (and welcome the comments of brokers on this statement).

If your broker insists that you must purchase units in a limited partnership, and no mutual fund will provide the same tax and financial benefits, then purchase the partnership in your IRA, traditional or ROTH, or another tax-deferred or tax-exempt account, so you tax professional does not have to deal with it on the 1040.

MUTUAL FUNDS

Mutual funds invest in all types of investments – domestic and international stocks, taxable and tax-exempt bonds, real estate, and limited partnerships.

Some funds invest in a mix of all investments and some funds limit investments to specific categories – small cap stock funds, growth stock funds, dividend paying stock funds, non or low dividend paying stock funds, international stock funds, corporate bond funds, either domestic or international, government bond funds, municipal bond funds, etc. etc. etc.

The taxability of dividends issued by mutual funds is determined by the rules for taxing the individual investments in the fund. Choosing what types of funds you purchase in currently taxed and tax-deferred accounts should be governed by the types of investments held in the fund.

Mutual funds can issue qualified dividends, non-qualified dividends, tax-exempt dividends, return of capital, and capital gain distributions.  Non-qualified dividends are taxed at ordinary income rates.  Return of capital distributions are not currently taxed as income – they reduce your cost basis in the fund.  Capital gain distributions are taxed at the lower capital gain tax rates.

There are “tax-efficient” mutual funds.  These funds can keep it's turnover low, especially if the fund invests in stock, and avoid or limit income-generating assets, such as dividend-paying stocks.  These funds should be held long-term in currently taxable accounts.

TAX-EXEMPT ACCOUNTS: ROTH IRAs AND 401(K)s, EDUCATION ACCOUNTS, HEALTH SAVINGS ACCOUNTS, AND MEDICAL SAVINGS ACCOUNTS

It really does not matter how you invest funds held in accounts whose distributions will never be taxed. 

Qualified distributions from a ROTH IRA or 401(k) account, a Section 529 qualified tuition program, a Coverdell Education IRA, a Health Savings Account, or a Medical Savings Account are totally tax free.  So taxes are not a consideration in determining where to invest the money.  Obviously you want to make sure that all distributions from these types of accounts are qualified distributions.

Before you invest you should consult a tax professional.  Do not rely on a broker for tax advice.

TTFN