Tax Tips

When reporting certain gains and losses on your investments, there are rules to follow, as well as techniques to save tax money.

Bond Swaps

The point of a bond swap is to lock in a tax loss by selling bonds that have fallen in value and reinvesting the proceeds in bonds that are not substantially identical to the bonds you sell. Often you can maintain the income stream from your bonds. Consider this example:

Assume you own $100,000 worth of AA-rated bonds with a 7% coupon and a maturity date in 2016. In November, as you begin your year-end planning, the market price of your bonds has slipped to $84,750. If you sell at that price, you'll have a $15,250 loss. At the same time, assume you can buy $100,000 face value of AAA-rated bonds, with a 7% coupon and a 2015 maturity, for $83,612.

If you sell the original bonds and buy the new ones, your bond rating increases from AA to AAA. You pull $1,138 out of the investment — the difference between what you got for the old bonds and what you paid for the new ones. And you can claim a $15,250 tax loss. If it offsets gains that otherwise would have been taxed at 15%, you save $2,288.

Municipal Bonds

Although interest from municipal bonds is exempt from federal income tax, the IRS doesn't ignore the gain or loss that results when you sell the bonds. If you sell a bond for more than your basis, the profit is a capital gain; if you sell it for less, it's a deductible capital loss.

Your basis is figured the same way as for taxable bonds. However, if you buy a tax-exempt bond at a premium (you pay a premium when the interest rate of the bonds you purchase is higher than the current rate on comparable bonds), you must amortize the premium over the period you own the bond. This amortization reduces your basis in the bond, but unlike a taxable bond, you can't deduct the amortized amount. The premium amortization isn't deductible because the interest isn't taxable.

If you buy a bond originally issued at a discount, you increase your basis each year as is required with taxable bonds, but you don't have to report the annual portion of the discount as income. It's tax-free, along with interest paid on the bond. You buy bonds at a discount when the interest rate on the bond at the time it's issued is lower than the current rate on comparable bonds.

Note that the amortized premium reduces any interest from the bond that may be taxable on your state return and the annual portion of the discount may be taxable on your state return.

Last-minute Sales

When you sell securities, you don't receive the proceeds until the third business day after the date of sale. For example, proceeds from a sale on Dec. 31, 2007, will not be received until Jan. 4, 2008. But the IRS requires that a gain or loss be reported on the return for the year in which the trade occurs, regardless of when settlement takes place.

Installment Sales

If you sell property, such as a vacation home, and the buyer will pay over a period of years, you report the gain as you receive the money, not in full in the year of sale. This method of reporting gain is called the installment method. You can't use the installment method for sales of publicly traded stocks and bonds. You can elect to report the entire gain in the year of sale, but it is rarely advantageous to do so. You should consider making this election if you have a large amount of capital losses for the year of sale or if you have a large capital loss carryover to the year of sale.

If you fail to include adequate interest in the contract, the IRS will recharacterize part of your gain as interest income. The lowest interest rate you can use is generally the lowest of the applicable federal rates for the month in which you sell the property, or either of the 2 preceding months.