The booming stock market is sending a go signal to investors. On the next corner, proposed tax changes are flashing a yellow light. And the Tax Reform Act of 1984 and its 1982-83 predecessors brought changes that must be dealt with now in investment decisions.
So with an eye for tax planning in 1985, how should an investor set the cruise controls for the rest of this year?
The easiest -- and perhaps most tempting -- course would be to go full speed ahead and damn the tax torpedos. The consensus seems to be that few of the controversial tax reform proposals made by former Treasury secretary Donald T. Regan, such as elimination of preferential tax treatment for capital gains, will be implemented. Many observers insist it won't happen this year because of the focus on reducing escalating budget deficits.
STOCKS: Market experts are unanimous in their agreement that the return last year to six months and a day as the period required for favored "long-term" treatment of capital gains for stocks acquired after June 22, 1984, was a boon for the market. They are less certain about what the impact would be of eliminating the tax break.
BONDS: Several changes that took effect this year and other proposed changes, as well as declining interest rates, cloud the picture for fixed-income investments. There are for the first time limits on capital gains on long-term taxable bonds bought at a market discount; a portion of the capital gain is treated as equivalent to interest income and taxed at ordinary rates.
This applies to bonds issued -- but not those outstanding -- after July 18, 1984; it exempts U.S. savings bonds and tax-exempt bonds. In the case of unit investment trusts packaged by brokers, the operative date is the issue date of the underlying bonds rather than the date the trust was formed.
Additionally, the amount of interest that can be deducted to finance market discount bonds is limited to net direct interest expense. The following example was offered by Leon M. Nad, national director of technical tax services with Price Waterhouse, a Big Eight accounting firm:
If an investor borrows $2,500 at 12 percent to buy a 10-year, $10,000 bond discounted to $2,500, he can only deduct $50 a year, or the difference between the loan interest cost of $300 and the annual discount of $250. The purpose is to prevent wealthy taxpayers from taking a deduction without adding income, he explained.
SHELTERS: "It's a difficult investment climate this year; people are going back to basics," said Nad. Nowhere is this truer than in tax shelters.
The government has launched a crackdown on abusive tax shelters, and the result has made some of them unattractive. Many shelter sellers must now register with the IRS, which assigns the tax shelter a registration number that taxpayers must include on their federal tax return. The IRS will notify the taxpayer if the shelter may not be acceptable. Moreover, the taxpayer using many shelters might be required to pay the 20 percent alternative minimum tax, which is designed to limit the advantage of tax shelters. Finally, the IRS plans to withhold refunds from taxpayers who use unacceptable shelters.
Wayne F. Nelson, a broker with Merrill Lynch in Washington and the author of several books on investing, advises against getting into multi-year write-offs at this time. Because shelters are not selling well, he said some shelter packagers now are even offering guarantees to take away some money from general partners and return it to investors if the rules go against them.
Ralph Goldman, senior vice president of Shearson Lehman Brothers Inc. in Muskogee, Okla., believes the only viable shelter henceforth will be real estate, even though Congress in 1984 cut back yearly deductions by increasing the depreciation period from 15 to 18 years. He warns the shelter will only be attractive if it has a positive cash flow from the start -- something only 10 to 20 percent of such shelters now have. He suggests shopping centers and warehouses.
OPTIONS: The tax treatment of broad-based market index options and all options on futures was equalized at 32 percent, and the investor is required to pay taxes on paper profits at year end. Previously, all these investments had been taxable either at the long-term rate of 20 percent of the short-term rate or 50 percent, and paper profits were not taxed. The change removes the advantage of the professional trader who used a straddle to carry gains forward from one year to the next and defer paying taxes, while giving the less sophisticated investor, who didn't use the strategy for tax purposes, a lower rate, according to Charles Robinson of the Futures Industry Association.
For investors concerned about possible future tax implications, some cautions from brokers and accountants may be in order. Treasury officials have emphasized that the the department's tax simplification proposals are designed not only to be revenue neutral but also not to favor one type of investment over another. Consequently, said Barry Goodman, a certified public accountant with Leopold & Linowes in Washington, it will be more important than ever to judge investments on their economic merits rather than their tax consequences. Nevertheless, subtle advantages and disadvantages are perceived.
The Treasury has proposed eliminating preferential tax treatment for capital gains. Opinion appears divided over the potential consequences. Moreover, it is not known when such a provision would go into effect if it were adopted.
On the assumption that it could go into effect immediately, Nelson advises clients to reconsider their positions at the end of the year if the proposal is approved for 1985 taxes. High-bracket investors could find it more profitable to take long-term capital gains this year than next. At the moment, Nelson likes convertible bonds as the cheapest way to get into the stock market.
Goldman believes that treating capital gains like ordinary income under a flat tax would be very bullish for stocks. This would give the latter investors the freedom to trade at will, whenever market conditions dictate, rather than having to time trades for tax purposes. Goldman thinks investors should stay long-term oriented during the second half of the year.
The Treasury suggested three income brackets: 35, 25 and 15 percent, and President Reagan said last week the top bracket might be even lower. Although upper-income investors would see capital gains taxes at 35 instead of a maximum of 20 percent, there would not be as great a difference for middle-income investors between 20 and 25 percent.
Now, dividends and capital gains are taxed. In the future, if a stock's appreciation keeps pace with inflation, the investor will benefit because there will be no tax on gains when adjusted for inflation, Goodman noted. There would be a slight disadvantage for upper-income investors with large unrealized capital gains on stocks that appreciate wildly but do not pay dividends.
For that reason, Harold W. Gourges Jr., a consultant to financial planners in Atlanta, advises them to include high-dividend-paying stocks in their clients' portfolios this year "even if they do not need the current income. Any elimination of the double taxation of corporate dividends would improve their performance well in advance of the fact."
The Treasury has proposed to lift the tax exemption on industrial revenue bonds. If issuers rush to bring their bonds to market this year before the provision takes effect, it could push prices down or yields up and present an opportunity for investors, said Nelson.
Proposed taxation of some municipal bond interest together with a maximum flat tax rate might have a positive effect on further reducing interest rates. Yet it could have a negative effect on bonds, according to Goodman. If the maximum tax rate is lowered from 50 to 35 percent, the spread between corporates and municipals will narrow. Because municipalities will have to pay higher rates, owners of existing municipals will see prices drop. To some extent the market has already reflected this, so Nelson said he doesn't expect to see major gyrations in the future.
Goldman said taxable bonds would still be attractive for upper-income investors. An investor in the 50 percent bracket now needs a pretax return of 18 percent to yield 9 percent, but only 13.5 percent if the bracket is reduced to 33 percent.
In addition to other moves against tax shelters, the Treasury has proposed retroactively taxing partnerships with more than 35 partners as corporations in 1990, thus preventing them from passing through real estate tax benefits to investors.
For investors in oil and gas shelters, Gourgues advises getting in as early as possible this year when most of the deductions on drilling costs can be taken while the 50 percent bracket still stands. He said investors should avoid tax incentive investments with deductions of any consequence beyond 1985.
Above all, says Gourgues, investors should plan their strategy in the light of current conditions; inflation and taxation will no longer be the twin nemeses. That means real estate and gold take a back seat to financial investments, and investors used to taking small trading profits in the past should think instead about buying and holding. He also counsels avoiding excessive leverage and reducing loans wherever future interest will exceed $5,000 more than the level of investment income. As for retirement plans, he suggests a rollover option now, coupled with lower future brackets, could be more desirable than a 10-year averaging for lump sum distributions.