Jane writes in to ask,

“I’m considering giving a large-ish gift to my son to help him purchase his first home. I think I understand that he won’t have to pay any tax on this gift, but I might have to. Is that correct? And how do I know if I have to pay any tax?”

Will the Recipient Have to Pay Any Tax?

The recipient of a gift does not pay any tax on that gift. Gifts are not included in taxable income, and the gift tax only applies to the person giving the gift, not to the person receiving it.

Will the Giver Have to Pay Any Tax?

The person giving the gift is subject to the gift tax, but, for a few reasons, there won’t actually be any tax owed in most cases.

First, none of the following types of transfers will result in taxable gifts:

• Gifts to your spouse,
• Gifts to a qualifying charity,
• Gifts to a political organization for its use, and
• Payments made directly to an educational institution or health care provider for somebody else’s tuition or medical expenses.

And for gifts that don’t fall under any of those exclusions, you can still give up to $13,000 per year to each recipient without the gift being taxable. (If you’re married filing jointly, you and your spouse can give a total of $26,000 per year to each recipient.)

In addition, even if you pass that $13,000 annual exclusion amount, you still have a long way to go before you actually have to pay any taxes. That’s because you also have a “unified credit” that exempts the first $5,000,000 of otherwise-taxable transfers that you make.

I say “transfers” rather than “gifts” because this credit is also the one that exempts your estate from estate tax when you die. So the more of it you use by giving gifts during your lifetime, the less of it you’ll have available to offset estate taxes for the benefit of your heirs. Still, for most people, $5,000,000 is plenty–more than enough to offset all the gifts they make during their lifetime as well as their entire estate.

Important note #1: Like tax brackets and many other aspects of our tax code, this $5,000,000 figure is something of a political football. It gets kicked around from year to year, so there’s no guarantee that it’ll still be set at $5,000,000–rather than at some lower number–at any particular point in the future.

Important note #2: If you exceed the annual $13,000 exclusion in any year, you do have to file a gift tax return (Form 709), even if you don’t have to pay any tax.

If you do end up exhausting your entire unified credit, the tax rates on the taxable amount of your transfer can be found in the instructions to Form 709.

How about an Example?

Raymond is an unmarried taxpayer. He’s never made any taxable gifts before. In 2011, he makes the following gifts:

• $80,000 to the American Red Cross,
• $10,000 to his nephew, and
• $20,000 to his niece.

How much gift tax will Raymond have to pay? Zero.

• Raymond’s gift to the Red Cross isn’t taxable because it’s a gift to a qualifying charitable organization.
• Raymond’s gift to his nephew isn’t taxable because it’s less than the $13,000 annual per-recipient exclusion amount.
• $7,000 (that is, $20,000 — $13,000 annual exclusion) of Raymond’s gift to his niece will be taxable. But Raymond will not have to pay any gift tax because of his $5,000,000 lifetime exclusion amount. After this year, his remaining exclusion amount will be $4,993,000 (or $5,000,000 — $7,000).

Note, however, that Raymond will have to file a gift tax return for the year because the gift to his niece exceeded the annual $13,000 exclusion.

Generation-Skipping Transfer Tax

If you make a gift to somebody two or more generations below you (e.g., your grandchild), the transfer could be subject to the generation-skipping transfer tax, which is a separate tax in addition to the gift tax. But, like the gift tax, it comes with a large lifetime exemption (currently $5,000,000) that you’d have to exhaust before owing any actual tax.

On Friday I mentioned one useful thing you can do with your portfolio during market declines (i.e., rebalance your asset allocation). Today I wanted to discuss another: check your taxable accounts for opportunities to tax-loss harvest. (Note: tax-loss harvesting does not apply to IRAs or other tax-sheltered accounts.)

To explain what tax-loss harvesting is, let’s look at an example.

Mary is in the 25% tax bracket. At the beginning of the year, Mary bought $100,000 of Vanguard Total International Stock Index Fund in her taxable account. As of today, it’s worth approximately $93,000. To tax-loss harvest, Mary would sell that fund, thereby recognizing a $7,000 capital loss.

Mary can use this $7,000 capital loss to offset any capital gains she realized this year. And if Mary’s capital losses exceed her capital gains for the year, she can use up to $3,000 of her net capital loss to offset ordinary income, thereby saving her $750 ($3,000 x 25%) on income tax. If she still has remaining capital losses after that, they can be carried forward to be used in future years (subject to the same limitation).

Potential Pitfall: Wash Sale Rule

Of course, after selling one of her holdings to realize a capital loss, Mary’s asset allocation will be out of whack.

But she must be careful! If, within 30 days before or after the date on which she sells her fund for a loss, she (or her spouse) purchases a “substantially identical” investment, she will have executed what’s known as a “wash sale.” And that means that the loss will be disallowed. (Essentially, it will be treated as if she hadn’t sold the fund at all.)

In other words: After selling an investment in order to tax-loss harvest, do not immediately repurchase the same investment. Instead, you have two choices:

1. Wait 31 days before repurchasing it, or
2. Purchase a fund that is similar but that would not qualify as “substantially identical.”

For example, if you go with option #2, any of the following funds is a relatively-close replacement for the fund(s) it’s paired with:

• Vanguard Total International Stock Market Index -> Vanguard FTSE All-World Ex-US Index
• Vanguard Total Stock Market Index -> Vanguard Large-Cap Index -> Vanguard 500 Index
• Vanguard Total Bond Market Index -> Vanguard Intermediate-Term Bond Index*

(Note: It likely makes sense to switch back to your original holding at some point though, given that these funds are different from each other.)

What’s the Point?

You may have noticed, however, that when you eventually sell the replacement fund, your capital gain will be larger than it would have been had you not tax-loss harvested (because the replacement fund will have been purchased at a lower price than the original fund).

To return to our example above, if Mary uses her $93,000 to purchase Vanguard FTSE All-World Ex-US Index, which she sells a few years later for $130,000, her long-term capital gain will be $37,000 rather than $30,000.

So did Mary still come out ahead? Yes, for a few reasons.

First, if nothing else, she deferred her taxes for a few years–in essence getting an interest-free loan from Uncle Sam.

Second, if she was able to use any of her $7,000 capital loss to offset ordinary income (or short-term capital gains), then the capital loss saved her money at a rate of 25% (because she’s in the 25% tax bracket). When she sells the replacement fund, the long-term capital gain will only be taxed at a rate of 15%.

Finally, if Mary had ended up dying before she sold the fund, the savings from tax-loss harvesting would be pure profit (because her heirs will receive the fund’s current market value as their cost basis when they inherit it).

When to Tax-Loss Harvest

Many investors check for tax-loss harvesting opportunities right before the end of the year–when they start thinking about taxes. While that’s perfectly fine, it can be advantageous to check several times throughout the year. Investments can be volatile, and it’s entirely possible that a tax-loss harvesting opportunity will arise early in the year, only to disappear before year-end.

*To the best of my knowledge, the IRS has not actually issued any firm guidance on what constitutes a substantially identical security when it comes to mutual funds. Personally, I’d be comfortable taking the position on a tax return that none of the above-mentioned pairings are substantially identical, given that they track meaningfully different indexes. But if you want to be absolutely sure, your best bet is to just wait 31 days, then repurchase the original fund.

Most people understand that reducing their tax burden is an easy way to improve their finances. And most people understand that a significant part of reducing their taxes is claiming every deduction for which they’re eligible.

Unfortunately, many people don’t fully understand that there are multiple types of deductions and that, depending on the circumstances, some deductions may be of limited value–or no value at all!

“Above the Line” Deductions

The first type of deduction is the “above the line deduction.” These deductions are particularly valuable because (assuming you meet the applicable requirements) you can claim them regardless of whether you itemize or use the standard deduction (which we’ll discuss in just a minute).

One easy way to know that something is an above the line deduction is that it appears on the first page of Form 1040. Some of the more common above the line deductions include:

• Traditional IRA contributions,
• Student loan interest,
• HSA contributions,
• Moving expenses, and
• One-half of self-employment tax.

Itemized Deductions

The next primary group of deductions are itemized deductions. Every year, you have the choice to claim either a) the standard deduction or b) your itemized deductions. In other words, itemized deductions are only valuable if they–in total–exceed the standard deduction.

The standard deduction amount changes per year, and it depends on your filing status, your age, and whether or not you are blind. (See here for 2011 standard deduction amounts.)

Some of the more common itemized deductions include:

• Home mortgage interest,
• State and local income taxes,
• Real estate taxes, and
• Charitable contributions.

2% Floor, Miscellaneous Itemized Deductions

Next, there’s a sub-category of itemized deductions known as “miscellaneous itemized deductions, subject to the 2% AGI floor.” This means that they’re only deductible to the extent that they–in total–exceed 2% of your adjusted gross income. (Your adjusted gross income is the last line on the first page of your Form 1040.)

In other words, it’s possible that you won’t be able to deduct these at all–even if you do itemize your deductions.

Common miscellaneous itemized deductions, subject to the 2% AGI floor include:

• Tax preparation fees,
• Unreimbursed expenses that you incur as an employee,
• Losses on traditional or Roth IRAs, and
• Legal fees related to producing taxable income.

Other Assorted Deduction Limitations

Finally, many deductions have limits on the amount that you can deduct and/or limits on the amount of income you can earn before you become ineligible for the deduction. For example, student loan interest is deductible as an above the line deduction, subject to two limitations:

• The total amount of the deduction cannot exceed $2,500, and
• If your modified adjusted gross income exceeds $60,000 ($120,000 if married filing jointly), the amount of the deduction you can claim is reduced. Once your MAGI exceeds $75,000 ($150,000 if married filing jointly), you cannot claim the deduction at all.

Other deductions have their own completely unique rules. For example, medical expenses are an itemized deduction that you can only claim to the extent that they exceed 7.5% of of your adjusted gross income.

What to Know About a Deduction

In order to determine whether or not a deduction will save you money on taxes, you first need to know:

• Is it an above the line deduction or an itemized deduction? (Or is it a different type of deduction entirely–a deduction you’d claim on Schedule C as a sole proprietor, for instance?)
• If it’s an itemized deduction, do you have enough itemized deductions to exceed your standard deduction?
• Does the expense/loss have to exceed a certain amount (a “floor”) before you can deduct it?
• Is there a limit to the amount you can deduct? (And is that limit affected by your income?)
• And, if you’re subject to the Alternative Minimum Tax, is the deduction allowed for AMT purposes as well?

Oblivious Investor reader Chris writes in to ask:

“Some time in the next month or so, I’m going to be inheriting about $45,000 worth of various stocks from an uncle of mine who passed away earlier this year.

I don’t have a clue what to do with a portfolio of individual stocks, so I’d like to sell them and allocate the money to my normal index fund portfolio. But I’m a bit worried to sell them, because I don’t know how to calculate the applicable capital gains taxes.

Inherited Cost Basis = Fair Market Value (Usually)

In most cases, if you sell the property soon after inheriting it, your capital gains should be fairly small. This is a result of the fact that, in general, when you inherit property, your cost basis is equal to the fair market value (FMV) of the property at the time of the decedent’s death.

Alternatively, if the administrator of the estate elects to use the “alternate valuation date” for the estate (and if this is the case, you should be informed of such an election), then your cost basis will be equal to the fair market value of the property on the earlier of:

• 6 months after the date of death, or
• The date that the property was distributed to you.

(Though again, this will usually result in any capital gains being small-to-nonexistent if you sell the property soon after receiving it.)

Note: Exceptions may apply for inherited property that was used in a closely held business or for farming

Holding Period for Inherited Property

Inherited property is considered to have a holding period of greater than one year, regardless of how long you’ve held the property or how long the decedent held the property. As such, any capital gains or losses will be considered long-term capital gains/losses.

Takeaway: Based on current tax law, the gains will be taxed at a maximum rate of 15%.

Special 2010 Cost Basis Rules

While we’re on the topic, it’s worth pointing out that if the person in question had died in 2010, the applicable rules would have been different. Specifically, administrators of estates of decedents who died in 2010 were allowed to choose between the rules that had originally been in place for 2010, or the rules that were scheduled to be in effect for 2011.

• If the administrator elected to use the 2010 rules (under which there was no estate tax), the recipients of the inherited property would have received the decedent’s cost basis in the property as their cost basis.
• If the administrator elected to use the 2011 rules (35% estate tax, but with a $5 million exemption), the recipients’ cost basis would be the FMV at the date of death (or FMV using the alternate valuation date, as described above).

As you might imagine, most estates were well below the $5 million exemption, so using the 2011 rules was usually best because it allowed the recipients to use the fair market value as their cost basis rather than having to use the (usually lower) cost basis of the decedent.

(Note: The above discussion relates to inherited taxable property. See here for inherited IRA rules.)

Given that the tax law is (usually) set up to reward things that Congress has decided are beneficial to our country, it’s no surprise that there are tax breaks available to people paying for higher education expenses.

Tuition and Fees Deduction

If you pay higher education expenses for yourself, your spouse, or your dependent, you may be entitled to the tuition and fees deduction of up to $4,000. In order to qualify for the deduction (an above-the-line deduction), you must:

• Have a modified adjusted gross income of less than $80,000 ($160,000 if married filing jointly),
• Not be able to be claimed as a dependent on somebody else’s return, and
• Not be married filing separately.

Qualifying Education Expenses

In order to be deductible, the expenses must be paid to a university, college, vocational school, or other postsecondary educational institution. Deductible expenses include tuition, fees, and other course-related expenses that are required to be paid to the institution as a condition for enrollment or attendance.

EXAMPLE: Jack is attending school to be a filmmaker. In addition to his tuition, he’s required to pay $500 per semester for use of the school’s film studio. Because he is required to pay the $500 to the school in order to attend classes, the expense can be included as a qualifying education expense.

EXAMPLE: Lee is attending school for a degree in Spanish. Each semester, he is required to buy several textbooks and DVDs to use for his courses. However, because his school doesn’t require that he buy the materials from the school—he could buy them online on Amazon, for instance—the cost does not count as a qualifying education expense.

Two more points of note about the tuition and fees deduction:

1. Room and board does not count as a qualifying education expense.
2. It doesn’t matter whether or not the money used to pay the expenses was obtained with a loan.

Education Credits

As an alternative to taking the tuition and fees deduction for higher education expenses, you may be able to use one of two credits: the Lifetime Learning Credit or the American Opportunity Credit.

Each year, for a given student, you can only use one of the three (the deduction, or one of the two credits). As such, this area is one in which it’s particularly valuable to know your options so that you can make the best decision.

As with the tuition and fees deduction, you can only claim a credit for higher education expenses paid for yourself, your spouse, or a dependent.

American Opportunity Credit

The American Opportunity Credit (a temporary modification of what used to be called the Hope Credit) is available for students who are in their first four years of postsecondary education and who are enrolled at least “half-time.” The amount of the credit is the sum of the first $2,000 of qualified education expenses paid for the student, plus 25% of the next $2,000 of qualified expenses. (Note that this means that the maximum credit per student is $2,500 for 2011.)

Your eligibility to claim the American Opportunity Credit begins to decrease as your modified adjusted gross income exceeds $80,000 for 2011 ($160,000 if married filing jointly). Once your MAGI reaches $90,000 ($180,000 if married filing jointly), you’ll no longer be eligible to use the credit.

In addition to the expenses that can be used when calculating the tuition and fees deduction, expenditures for “course materials” can be used for purposes of calculating the American Opportunity Credit. “Course materials” includes books and supplies needed for a course, whether or not the materials are purchased from the educational institution as a condition of enrollment or attendance.

Lifetime Learning Credit

The Lifetime Learning Credit is available for any student enrolled in postsecondary education or any employee enrolled in courses to acquire or improve job skills. The amount of the credit is 20% of the first $10,000 of qualified education expenses. (Note that this means that the maximum credit is $2,000 for 2011.)

As with the tuition and fees deduction, the only expenses that can be considered when calculating the Lifetime Learning Credit are:

• Tuition and fees, and
• Other course-related expenses that are required to be paid to the institution as a condition for enrollment or attendance.

Your eligibility to claim the Lifetime Learning Credit begins to decrease as your modified adjusted gross income exceeds $50,000 for 2011 ($100,000 if married filing jointly). Once your MAGI reaches $60,000 ($120,000 if married filing jointly), you’ll no longer be eligible to use the credit.

Unlike the American Opportunity Credit, there is no limit to the number of years that the Lifetime Learning Credit can be used for a given student. However, the Lifetime Learning Credit can only be claimed for one student per tax return per year.

EXAMPLE: Katie and Alex are siblings. Alex is a freshman in college, and Katie is a senior (in her fifth year of college). With the help of some student loans, their family spends $10,000 for tuition for each of them for the year.

The family should probably claim the American Opportunity Credit for Alex, because it will allow for a credit of $2,500, as opposed to the $2,000 that would be allowed via the Lifetime Learning Credit. Also, by not using the Lifetime Learning Credit for Alex, the family can still use the Lifetime Learning Credit for Katie. (Katie is ineligible for the American Opportunity Credit, because she is in her fifth year of college.) In total, the family will be able to claim $4,500 of education-related credits.

Student Loan Interest Deduction

If you pay student loan interest during 2011 and your modified adjusted gross income is less than $75,000 ($150,000 if married filing jointly), you may be qualified for an above the line deduction for the amount of interest paid (up to $2,500). In order to qualify:

1. The loan must be taken out solely to pay for qualified higher education expenses,
2. You (and your spouse, if you have one) must not be claimed as a dependent on anybody else’s return, and
3. If married, you must file jointly.

Simple Summary

• If you pay higher education expenses for yourself, your spouse, or a dependent, you can likely deduct up to $4,000 of those expenses per year.
• Students in their first four years of postsecondary education may be eligible to claim the American Opportunity Credit (of up to $2,500 for 2011).
• Students enrolled in postsecondary education may be eligible for the Lifetime Learning Credit (which can be as large as $2,000 in 2011). Only one Lifetime Learning Credit can be claimed per tax return per year.
• For a given student’s expenses, you can only use one of: the American Opportunity Credit, the Lifetime Learning Credit, or the tuition and fees deduction.
• If you pay student loan interest, you may qualify for an above the line deduction for the amount of interest paid, up to $2,500.

One topic that’s popped up several times recently in readers emails is that of deduction timing. I thought it might make sense to knock out the three most common related questions before wrapping up tax season.

Service Performed in One Period, Payment in Another

“I had a medical procedure performed in December of 2010, but didn’t receive/pay the bill until January 2011. For the purpose of claiming this as an itemized deduction, would it count in 2010 or 2011?”

Most small businesses and darned-near every individual person are “cash basis” taxpayers. That means that:

• Income is recognized when it’s received (as opposed to when it’s earned), and
• Expenses are recognized when paid (as opposed to when the corresponding service is performed).

So for the person above, the deduction would apply to 2011 (when the payment was made) rather than 2010 (when the procedure was performed).

Related note: Income is considered to be received whenever you have “constructive receipt” of it–that is, whenever it’s made available to you without restriction. So, for example, if somebody writes you a check and hands it to you, you’ve now “constructively received” it, even if you don’t actually deposit it in your bank account until a future tax period.

Deduction for Payments by Credit Card

“I paid for a deductible expense in December 2010 using a credit card, then I paid the credit card off in February 2011. When do I claim the deduction?”

For expenses paid by credit card, the relevant date is the date of the transaction, not the date that you actually pay the credit card off.

Deduction for Computers and other Long-Lived Assets

“I purchased a computer for my business at the end of 2010, but I expect to use it for a few years. When do I claim the deduction?”

For costs that are expected to provide a benefit for greater than 12 months, the general rule is that they must be capitalized (recorded as assets) and amortized/depreciated over time.

If, however, you purchase equipment for use in a business, you can usually use the “Section 179 election” to deduct the entire cost in the year you place the equipment into service.

• Exception #1: If you’re placing a lot of equipment into service in a given year, limitations may apply. (The exact limit changes from year to year. For 2011, you don’t need to worry unless you’re placing more than $500,000 of equipment into service.)
• Exception #2: If you use the equipment partially for personal uses, you can only deduct the business-use percentage of the cost. (That is, if you use it 75% of the time for business, you can only deduct 75% of the cost.)
• Exception #2a: If the equipment is “listed property” (computers, phones, cameras, and just about anything else fun) and the business-use percentage is 50% or below, you cannot claim the Section 179 election. That is, you’ll have to depreciate the equipment over time.