Tax traps for US investors

[muscleman]

Let's list all the tax traps for US investors so we can all benefit.

Let me start:

1. PFIC: Passive foreign investment companies. This is the trickiest of all. It has to be a foreign company, with more cash and cash equivalent assets than other assets, and investment income. Banks and insurance companies excluded. Note that a lot of small biotech companies easily fit this category. Also some ETFs? Foreign mutual funds? If you bought a PFIC and didn't sell by the end of the year, then good luck. Filing returns per PFIC takes a long long time. https://en.wikipedia.org/wiki/Passive_foreign_investment_company

Also, if you invest in a fund and the fund happens to own a PFIC, I wonder if that can cause big problems?

 

2. LP (limited partner): A lot of oil and gas companies are LP instead of corporations. They send you K1 that you have to fill out for tax filing, which is very annoying. Sometimes you could lose money trading LP shares, and at the same time, pay for the LP's share of income tax.

3. REITS? I don't have a good understanding of REIT. They seem like LPs, but will I get K1 forms? Or do I just treat it like a regular stock? They have to pay 90% of their income out, so dividend yield is usually high just like the LPs.

 

Anything else?

[aws]

I had a client who bought Canadian mutual funds in the 80s which he later found out were PFICs.  However bad you think the tax rules can be for those, it gets much worse when you hold them a long time.  All gains are assumed to be earned ratably over the holding period, so like if you held 40 years and had a 400k gain, it assumes you made 10k in each year.  And then you calculate the tax for those 40 year ago earnings plus interest due until today.  The way the formula works it can result in tax rates of over 100% which is bonkers.  You can't even donate it or die with it either as both of those are considered taxable sales.

 

The LP issue can also generate taxable income for you in a wide variety of states.  Technically you might need to file tax returns in a dozen states to report $10 here and $50 there as a result of owning one.  I doubt they'd really come after you if you didn't, but if you ask them they usually do want you to file even for a pitiful sum.

[Gregmal]

I had a client who bought Canadian mutual funds in the 80s which he later found out were PFICs.  However bad you think the tax rules can be for those, it gets much worse when you hold them a long time.  All gains are assumed to be earned ratably over the holding period, so like if you held 40 years and had a 400k gain, it assumes you made 10k in each year.  And then you calculate the tax for those 40 year ago earnings plus interest due until today.  The way the formula works it can result in tax rates of over 100% which is bonkers.  You can't even donate it or die with it either as both of those are considered taxable sales.

 

The LP issue can also generate taxable income for you in a wide variety of states.  Technically you might need to file tax returns in a dozen states to report $10 here and $50 there as a result of owning one.  I doubt they'd really come after you if you didn't, but if you ask them they usually do want you to file even for a pitiful sum.

 

In the event of the LP issue, from what I've heard, it may or may not be more time and cost productive(vs doing it yourself or paying your accountant) to just report the income on federal, and then have the states send you a notice and just pay it then plus whatever incremental interest charge/fine you'd get on $10 or $50  or whatever.

[aws]

Possibly, but if it is a material amount of tax you would be double paying by doing it that way.  All the tax paid to another state can be claimed as a credit on your home state, but only if you actually file the return in that state, not just paying taxes after the fact.  Most LPs aren't that bad, like oil and gas ones usually throw off losses anyway, but some hedge fund K-1s can be terrible.

[Foreign Tuffett]

Possibly, but if it is a material amount of tax you would be double paying by doing it that way.  All the tax paid to another state can be claimed as a credit on your home state, but only if you actually file the return in that state, not just paying taxes after the fact.  Most LPs aren't that bad, like oil and gas ones usually throw off losses anyway, but some hedge fund K-1s can be terrible.

 

Fortress Investment Group

#NeverForgetNeverForgive

 

 

[aws]

You can accidentally create a wash sale where the basis will be permanently lost.  It happens if you buy shares in your IRA during the wash sale period where either you or your spouse had sold those shares in another account you own for a loss.  The purchase requires you to zero out the loss on the original sale in the taxable account, but because the entity that holds the new shares (the IRA) is tax-exempt, when you later sell the stock in the IRA you can't do anything with the basis from the wash sale.  It just disappears forever.

 

Wash sales can also be triggered by actions in other types of entities you own like partnerships or corporations, but at least there you may not lose the value of it permanently.  However, with all of these situations your broker isn't going to be reporting these to the IRS, most likely not even when both accounts are held with them,  so it would be an issue that you would need to self-report or it would have to get picked up when you are under audit something.

[NoCalledStrikes]

One not yet mentioned is straddle options require different tax treatment. Heck, even  vanilla options can mess up your existing equity holding periods.  I am not the world’s most interesting trader so “I don’t usually trade options, but when I do, I always discover new tax rules.”

 

 

[Grafter]

PTP/LPs, like others have pointed out, can cause a lot of headaches:

 

1)  Gains and losses in multiple states, that may require filing multiple state tax returns.  Especially if there is a large sale or it produces a lot of ordinary income (Stonemar did that a few times, and I know that PA went after unitholders; I wouldn't be surprised if OK goes after MMP holders this year, due to the capital gain associated with the sale of a plant there). 

 

2)  State level bonus depreciation adjustments, which impact both the annual losses and gain when sold.

 

3)  Most PTPs are passive to the unitholder, so losses are not deductible until there is offseting income or you dispose of the shares.  But, you also need to be tracking and reporting the suspended losses (and if you change accounting firms or software, it is very easy for this info to be lost).

 

4)  You generally need to track your own basis, both to make sure that the K-1s report the right beginning balance and for whatever you purchased or sold during the year; as well as to see if you have distributions in excess of basis (which are capital gain).  In addition, when you sell, as the sale of a partnership is treated as selling the underlying assets, some of the gain will most likely be ordinary (as depreciation recaputure).  You will also be hit with basis adjustments (to reflect the various partnership distributions you've received over time).

 

5)  If you hold in an IRA, you have to be on the look out for UBIT income.  And it does appear that in some cases, the IRS is treating the ordinary gain on sale of a PTP as UBIT income, which requires a 990-T to be filed (which most custodians will charge you for) and you will need to pay the appropriate tax from the IRA assets.

 

Other than that, there are:  1)  The issues with mutual funds, such as if they have a number of redemption0, they will need to sell, which very well may result in capital gains (which isn't an issue for ETFs).  In addition, due to the mutual fund structure, if you buy right before the ex-dividend date, you will be hit with the full impact of the year's tax attributes that are distributed (vs buying right after, at the lower share price).  2)  All of the foreign asset filings, if you hold foreign assets (and especially so with PFICs).  This can range from the FBAR and Form 8938, to needing to read the tax treaty with that country to determine what your foreign filing requirement is.  As the penalties for not filing when you need to file are significant (easily in the 5 digits and up).