Almost everything you own and use for personal purposes, pleasure or investment is a capital asset. The IRS says when you sell a capital asset, such as stocks, the difference between the amount you sell it for and your basis, which is usually what you paid for it, is a capital gain or a capital loss. While you must report all capital gains, you may deduct only your capital losses on investment property, not personal property.
A “paper loss”— a drop in an investment’s value below its purchase price — does not qualify for the deduction. The loss must be realized through the capital asset’s sale or exchange.
Capital gains and losses are classified as long-term or short-term, depending on how long you hold the property before you sell it. If you hold it more than one year, your capital gain or loss is long-term. If you hold it one year or less, your capital gain or loss is short-term. For more information on the tax rates, refer to IRS Publication 544, Sales and Other Dispositions of Assets.
If your capital losses exceed your capital gains, the excess is subtracted from other income on your tax return, up to an annual limit of $3,000 ($1,500 if you are married filing separately).
Capital gains and losses are reported on Schedule D, Capital Gains and Losses, and then transferred to line 13 of Form 1040. There is a worksheet in last year’s Instructions to Schedule D to figure a capital loss carryover to this year. This is usually a very complicated matter, so please contact us so that you may receive the professional advice you deserve.
This will be the first of numerous segments discussing portfolio allocation, and recommendations in an volatile environment. Please feel free to email us with questions/comments.
What is Asset Allocation?
At the base of any portfolio allocation is the premise that the best-performing asset varies from year to year and is not easily predictable. At the same time, poorly performing investments could be the result of multiple factors including, but not limited to, market conditions, earnings, rumors, and/or changes in board/management. The thinking goes, by having a mixture of asset classes, sectors, and geographies, an investor is best prepared to achieve the best risk adjusted return* by hedging against individual risk drivers while diversifying to capture holistic opportunities.
The laymen’s thinking almost makes more sense — an allocation is the equivalent of a pie (the sum total of different slices). Each slice is the equivalent of an asset class, sector, or geography. As these classes (slices) increase/decrease (grow/shrink) the pie (allocation) must be rebalanced. An investor would effectively sell winners (bigger slices) and buy losers (smaller slices) to get the allocation (pie) back into symmetrical shape. After rebalancing, the allocation (pie) is larger than it was initially — the investor made money by diversifying.
A Note on Risk Adjusted Return*
We live in a risk-reward world, that is the more risk you take the more benefit you might be able to derive from that risk (at the same time, higher risk increases the extent to which you can lose). Entrepreneurs take a phenomenal risk in building businesses. Beyond the financial and time investment, an entrepreneur foregoes the opportunity to build a career and achieve stable income. While they might succeed and profit tremendously from a successful business venture, they may decide to exit the business, losing any investment made while owing significant debt. The term “Risk Adjusted Return,” aims to find that happy level of risk by which a rational and risk averse investor is willing to subject their money to in order to achieve an acceptable return.
So what is the proper allocation for you to achieve the risk adjusted return that you desire? Well, the first that you should probably determine is how much risk are you willing to take? Shaping an asset allocation is going to be largely impacted by your personality — will you be able to sleep at night knowing that your money is being subject to significant market fluctuations? Do you need immediate liquidity? These are important questions to ask yourself before you begin designing your own allocation (or buying pre-packaged products [to be discussed in the next segment]).
For those individuals who aim to preserve their capital (and this is their #1 priority) I would generally recommend that a portfolio be be structured to maintain in excess of 80% of their value in cash and cash equivalents (money markets, treasuries and commercial paper). High liquidity is a major benefit of this portfolio allocation — many individuals favoring this portfolio style have a need for capital within the next 12 months. Please note, while this structure may have less market risk, it does open you up to the risk of losing money over time because the appreciation of assets may not keep pace with inflation.
For individuals desiring current income, we can expect a similar (majority) component of the portfolio to be composed investment-grade, fixed income obligations of large, profitable corporations, real estate (usually REITs), treasury notes, and, to a lesser extent, shares of blue chip companies with long histories of continuous dividend payments. Usually, the investor who prefers this type of allocation is one who is income-oriented — usually nearing retirement or structuring some way to preserving the principle (with some upside potential) of a significant cash inflow (inheritance, etc.).
For most of us, we can find a certain level of comfort in a “Balanced Portfolio.” Most people find a sense of emotional comfort in knowing that this portfolio is structured as to balance long-term growth and appreciation of assets and current income. An ideal mix of assets would include those that generate cash as well as those that appreciate over time. Well balanced portfolios mitigate the risk of medium-term investment-grade fixed income obligations, shares of common stocks in leading corporations (some but not all that pay dividends), and real estate holdings via REITs. Generally, a balanced portfolio is always vested (meaning very little is held in cash or cash equivalents unless the investor (either you or a portfolio manager) has determined that there are no compelling opportunities.
A like-kind exchange, sometimes called a 1031 exchange after the section of the Internal Revenue Code that governs these transactions, is the exchange of one business or investment property for another. Provided the property you receive is of a “like kind” to the property you transfer, and all other requirements are met, no gain or loss is recognized on the income deferred as a result of the exchange. This has made like-kind exchanges a popular technique for investors looking to defer the payment of taxes on capital gains. When it comes to like-kind exchanges, though, even the most straightforward transaction is complicated.
If there is a “basic” like-kind exchange, it takes the form of a simultaneous exchange. You transfer business or investment property to another party in return for similar property. For example, let’s say you own a piece of land that has a basis of $200,000 (your cost) and a fair market value of $400,000. If you were to sell the property, you would recognize $200,000 in gain. Instead of selling the land, however, you exchange it for a rental property owned by another individual. If all the conditions of IRC Section 1031 are met, you do not recognize any gain as a result of the exchange (recognition of any gain is deferred until you sell the rental property). If you receive cash in addition to the rental property, gain is recognized to the extent of the cash received.
With a deferred exchange, you give up your original property before receiving the replacement property. During the time that you’re looking for a replacement property, you can’t touch the proceeds from your original property (taking control of cash or proceeds before the entire like-kind exchange is complete can disqualify the transaction). For this reason, deferred like-kind exchanges generally involve executing a written exchange agreement with a qualified intermediary or other exchange facilitator, such as a bank, trust company, or attorney, that you pay to handle the transaction. The intermediary, who may assist you in locating a replacement property, is responsible for keeping the proceeds from your original property separate in an escrow account until the exchange is complete.
In a deferred exchange, you have 45 days from the date that you relinquish your original property to identify, in writing, potential replacement properties. You must then receive the replacement property and close the exchange within 180 days from the date you relinquish your original property, or by the due date of your tax return (including extensions) for the tax year in which you relinquished your original property, whichever is earlier.
Tenancy-in-common (TIC) exchanges
With a TIC exchange, you exchange real property, and as replacement property, you receive a partial ownership interest (you’re a co-owner, specifically a tenant-in-common) in commercial real estate. For example, you might exchange a piece of land with a fair market value of $400,000 for a 10% TIC ownership interest in a $4 million commercial property. TIC interest offerings include partial ownership interests in manufacturing facilities, office buildings, and malls.
These exchanges are extremely complicated. In fact, for a TIC interest to even qualify as potential replacement property in a like-kind exchange, there are extensive conditions that must be met. Most TIC interests are sold as securities, and are not available to the general public. TIC interests are generally available only to individuals who qualify as “accredited” investors (basically, those with a net worth greater than $1 million, or income of at least $200,000–$300,000 for a married couple–for the prior two years). TIC offerings are non-conventional investments, and while they might provide ownership opportunity in a larger property than you might otherwise be able to afford, they are not suitable for all investors. In addition to the significant fees and lack of liquidity generally associated with TIC exchanges, you’ll typically have little or no day-to-day control over the TIC property.
It can’t be overemphasized: like-kind exchanges are complicated, and there’s simply no way to cover all the rules here. So, before you even consider a like-kind exchange, you should familiarize yourself with the details, including all tax aspects of an exchange. Note as well that special rules apply to exchanges between related parties.
A like-kind exchange can be a powerful strategy for investors and business owners, so it’s worth understanding. But, if you’re interested, make sure that you contact a qualified professional who can help you navigate the intricate rules that apply.
Jason Gilbert is Managing Director of RGA Investment Advisors LLC. He has over 10 years of experience in investment advisory, including portfolio construction, financial strategy, and advanced planning for high-net worth and institutional clients. He maintains an extensive background in both forensic accounting and personal finance, and serves as a fiduciary and trusted partner to his long-standing clients.