Do you have to worry about the wash sale rule when shorting a stock?
We'll answer that riddle in today's Tax Forum. We'll also discuss college savings choices for an active trader and investigate whether you can deduct interest on a 401(k) loan.
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Short Sales and Wash Sales
Does the wash sale rule apply to short sales of securities? Given that one sells to start the transaction and buys to conclude it and never really owns the security, I'm not sure how this is handled for the wash sale rule. Help please. -- Ron Pipkin
Just because you're short, doesn't mean you can duck the wash sale rule.
When you enter a short sale you borrow a security from a broker and then sell it. Later on you buy the stock back -- hopefully at a lower price -- and return it to your broker.
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Only when the short position is closed -- the stock is delivered -- is there a taxable event.
It is that taxable event that determines whether you have a wash sale issue. (Read our
monster piece if you want to learn more about the wash sale rule.)
If you generated a loss when you closed the short, you do have to be cognizant of the wash sale, says Dave Matthews, a manager in the financial instruments group at
Deloitte & Touche
That means if you buy a "substantially similar security" 30 days before or after the close of that short, or if you re-enter the short position during that same window -- your loss will be disallowed because it will be considered a wash sale.
Sorry, but as with death and taxes, you can't escape that pesky rule.
Actively Trading for College
I have a couple of sons who will be taking off for college in about nine years. I need to grow their college accounts big time! I expect to actively trade their accounts with a variety of stocks to maximize returns, as I have in my own brokerage IRA. However, I'm concerned about taxes, which would seem to be excessive with frequent trading. What's the best account setup (ROTH, UGMA, etc.) for minor children education accounts? -- Ted Boriack
Let's take these options one at a time.
To open a Roth IRA in your kids' names they need to have earned income (i.e. wages, salaries, tips, other employee compensation). Even then, their contributions are limited to $2,000 a year. And don't forget that although you can withdraw the money penalty-free for higher education, you will owe tax on any earnings.
The big thing to remember with the
Uniform Gifts to Minors Act
Uniform Transfers to Minors Act
is that your kids get full control of the account at the age of majority. In many states, that's 18. So you have to trust that your kids are really committed to going to college and not to buying a new BMW.
If you trust your kids, you should open an UTMA account, not an UGMA, suggests Dee Lee, a certified financial planner and co-author of
The Complete Idiot's Guide to 401(k) Plans
. You can actively trade with a UTMA. You can't with an UGMA. (Actually, many states have replaced the UTMA with the UGMA, anyway, because UTMA allows the custodian more control.)
Also keep in mind that since the Roth will be in your kids' names and so will the UTMA once they reach the age of majority, these accounts will work against your children's financial aid chances.
Another option is to simply trade in your own account. Then you won't have the contribution limitations and you won't have to worry about your kids being slighted for financial aid. But as you know, you'll be smacked with short-term capital gains at your own tax rate.
A better way to go may be to invest for the long term. Then when your children are ready to go off to school, give them just enough stock to pay that year's tuition bill. Your children will most likely pay long-term capital gains tax at only 10%, compared with your 20% rate.
In addition, check out the new state college savings plans (a.k.a. 529 plans). They come in two main flavors: a prepaid tuition plan that lets you buy a future tuition credit at today's prices, and a tax-deferred savings plan that acts like a nondeductible IRA. (Check out a previous
story for these plans' perks.)
Two other benefits of 529 plans: You pay no state or federal taxes on the plans' earnings until it's time to withdraw from them. Then your children will pay the tax at their rates. Also, you maintain complete control over the account forever -- unlike the UTMA.
Deducting Interest on a 401(k) Loan
I read Dear Dagen's very informative article on using 401(k) borrowings for residence purchases, and I wanted to let you know about a little-known tax loophole that allows you to write off the interest you pay back on loans taken from 401(k)s for residence purchases. If the plan is given a security interest in the property, the interest is then fully deductible. I took a loan from my 401(k) plan a few years back at 10% interest and have been following the practice of deducting the interest paid on my tax returns ever since. The only extra step I had to take in implementing this method was in recording the lien with the recorder's office of the county in which I bought the property. One tiny hassle involved was that, when I refinanced, I had to have the plan holder sign a subordination agreement. But otherwise there have been no problems. -- Maria Sena Dulfu
Your company has secured your 401(k) loan with a mortgage, says Art Ford, a certified public accountant at
in Tewksbury, Mass. Lucky you. That's why you can deduct your interest payments.
But let's make it perfectly clear: This is not a common practice because it's a big pain in the you-know-what for the plan's trustee.
Here's why. The plan first has to institute an investment program that allows a certain percentage of plan assets to be invested in residential mortgages. That's what allows the plan to use a mortgage lien against the property as collateral for the loan.
But this does not come cheap for your plan's trustee. To start, there are transaction costs associated with creating a mortgage and registering the property with the county. In a worst-case scenario involving a default, your house could be sold to pay back your plan.
This is not a cheap process for you either. Since you are limited to a $50,000 loan from your 401(k), the odds are good that you've taken out another mortgage to purchase your home. That means you've incurred double the transaction costs.
TSC Tax Forum aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances.