Investors Need a Strategy to Soften the Bite on Taxable Gains

Every investor wants to buy low and sell high. And thanks to a stunning stock market performance, millions of Americans were able to brag about dazzling investment coups last year.

But when spring is in the air, a young investor’s whimsy turns into just another taxable gain. Not to mention a nightmarish filing season--especially now that it seems certain the promised capital gains tax cut, once expected to be retroactive to the beginning of 1995, is unlikely to pan out.

Still, savvy investors can employ a few strategies to significantly reduce the federal tax bite on their investment earnings. Here are a few tips.

* Remember to account for trading costs. When you sell a stock, your taxable gain or loss is computed by subtracting the purchase price from the sales price. Seems simple enough.

However, many investors make the costly mistake of failing to factor their trading costs into the equation. In fact, you can and should subtract the cost of buying and selling securities--brokerage commissions or fund sales “loads”--from the taxable gain.

* Deduct investment interest against investment income. If you paid interest expenses because you borrowed to buy stocks or taxable bonds, you can deduct those costs from your gain as well, says Philip J. Holthouse, partner at Holthouse Carlin & Van Trigt in Los Angeles.

But to deduct investment interest, you must have paid the debt during the tax year--if you were billed but didn’t pay in 1995, the cost isn’t deductible--and you can only deduct investment interest expenses to the extent that you have investment income, Holthouse says. But if you borrowed money to buy tax-exempt bonds, your borrowing costs are not tax-deductible.

* Declare miscellaneous expenses. If you buy magazines, newspapers, research reports, newsletters, books or other items in order to make savvier investment decisions--and bigger profit--you can deduct these costs as miscellaneous itemized deductions. However, miscellaneous itemized deductions--which also include unreimbursed business and job search expenses, tax preparation fees and appraisal fees to determine the fair market value of donated property--are only deductible once they exceed 2% of your adjusted gross income. In other words, someone earning $50,000 annually would only be able to write off miscellaneous itemized deductions that exceed $1,000.

As a result, it makes sense to “bunch” these expenses, where possible. For example, instead of renewing your newsletter subscription once a year, take the cut-rate two- or three-year deal. Any similar expenses that can be pushed into the same year will boost your chance of rising above the deduction floor.

But would it be possible to claim that you are in the business of investing and consequently deduct 100% of your investment-related expenses, forgetting the 2% floor? It is possible, says Holthouse, but not likely unless you are truly in business--buying and selling securities for yourself and others.

Technically, the tax code breaks investors into three categories: the plain vanilla type, who are subject to the 2% floor; brokers, who buy and sell securities for others; and traders, who buy and sell securities on their own behalf as a business.

The definition of a trader is amorphous. However, tax court cases indicate that trader status is linked to the taxpayer’s efforts to turn a profit from daily market movements. For example, one taxpayer who was successfully classified as a trader showed he had made 11,000 securities trades in a single year.

* Don’t forget about reinvested dividends. When investors automatically plow their dividends and interest distributions back into additional shares of the company or mutual fund, they frequently forget to account for them when figuring their capital gains, tax advisors say.

However, when you invest in mutual funds, your profit is “distributed” and taxed every year--regardless of whether you received it in cash or simply used it to buy a bigger stake in your fund through an automatic dividend reinvestment plan. The same holds true for reinvested dividends in individual stocks. If you fail to account for reinvested dividends, you’ll be taxed twice on the same earnings. Be sure to check your records and adjust your cost-basis to reflect all the shares you’ve purchased.