December 2015 Tax Tips

This issue’s “Tax Tips” provides information on passive foreign investment companies, how to deal with concentrated stock positions, and a Ninth U.S. Circuit Court of Appeals ruling that the mortgage interest deduction limit applies on a per-taxpayer basis, reversing a 2012 Tax Court decision.

Beware the passive foreign investment company

Have you considered investing in a passive foreign investment company (PFIC)? If so, think twice. The rules for such investments are quite onerous, and apply to many foreign investments.

A foreign corporation is a PFIC if 1) 75% or more of its gross income is passive (interest and dividends, for example), or 2) at least 50% of its assets are held for production of passive income. In other words, this applies to most foreign-registered mutual funds, hedge funds and private equity funds.

U.S. investors in PFICs are subject to a highly punitive tax regime. In addition to complex, costly reporting requirements, capital gains and dividends generally are taxed as ordinary income at the highest federal rate (currently 39.6%) regardless of your actual tax bracket. Deferred gains or dividends are treated as if they were received ratably over your holding period, and you pay interest on the deferred tax.

To avoid this harsh treatment, file one of two elections that essentially require you to pay tax on PFIC income as it’s earned, whether it’s distributed to you or not. Fortunately, there are exceptions for the election filing requirements which may apply if you own the PFIC through another entity and if your interest in PFIC shares is below certain thresholds.

Dealing with concentrated stock positions

If investments are concentrated in a single stock, you may want to diversify your portfolio. But selling a large number of shares may trigger a significant tax liability. You can soften the blow by selling your shares over time to spread out the tax burden. Or defer the tax by trading for shares in an exchange fund, or donate shares to a charitable remainder trust, which sells the shares tax-free, reinvests the proceeds and pays you a portion of its income.

If you prefer to keep the stock, diversify your portfolio by buying other securities. If you’re short on funds and not averse to some additional risk, you might even buy additional investments on margin, using the stock as collateral.

9th Circuit doubles mortgage interest deduction for unmarried co-owners

Taxpayers are entitled to deduct interest on up to $1 million of acquisition indebtedness and $100,000 in home equity indebtedness on a primary residence and one additional residence. But what happens if unmarried taxpayers own a home together and borrow more than $1.1 million combined?

Recently, the Ninth U.S. Circuit Court of Appeals ruled that the deduction limit applies on a per-taxpayer basis, reversing a 2012 Tax Court decision holding that the limit applies on a per-residence basis. That is, each co-owner may deduct interest on up to $1.1 million of debt.

© 2015

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