By Joseph P. Nicola, Jr., CPA, JD

Published November 2008

Recent market declines impacting all types of investments have captured a great deal of media attention lately. As one might expect, high net-worth individuals, such as entrepreneurs and others in the learned professions, have been particularly vulnerable. In many respects, physicians are at the center of this group. Physicians, as in the case of other well-advised high-net-wealth individuals, have not been bashful about engaging in alternative sources of investing, principally in ways that are typically consistent with their personal interests. Examples include jewelry, automobiles, collectibles, commodities and vacation real estate. These types of investments may supplement, or perhaps take the place of, traditional investments, such as stocks and bonds.

Since mid-2007, the so-called credit crunch has affected all aspects of investing activity, but no more so than in the major stock indices and the residential real estate market. As in other periods of decline, common courses of traditional action are recommended.

Perhaps the most simple advice in a period of market decline revolves around asset disposition planning. The target of such planning is typically stock and similar investments. Individuals should review their portfolios and identify those assets that have declined in value. In such cases, a decision should be made as to whether to sell an investment at a loss to offset any potential taxable investment or other income. Individuals can offset capital gains realized during the year, as well as up to $3,000 of ordinary income, such as salary income, earned during the year.

More important, careful planning dictates that, if possible, long-term losses (i.e., gains from the sale of stock held for more than one year) should be generated in such a way that can be used to offset ordinary income rather than other capital gains. In this way, the effect will be to reduce ordinary income, which is taxed at a much higher rate than long-term capital gains. In engaging in such planning, individuals should focus on investments in which they do not wish to continue to maintain a position.

Care must be taken to avoid the so-called "wash-sale" rules imposed by the tax law. For example, an individual generally cannot sell an investment at a loss, then immediately purchase the same stock in order to maintain a position in the investment. Referred to as the "wash sale" rule, the law prohibits such abuse by denying the loss deduction (although, if carefully applied, individuals can avoid the impact of the wash sale rules while maintaining a position in an investment).

One of the more intriguing aspects of investment planning relates to the current political environment. Currently, most corporate dividends are taxed at a maximum rate of 15 percent. Conventional wisdom has historically suggested, however, that in the case of a closely-held corporation, such as a physician’s practice, dividends should be avoided in favor of compensation, since dividends are taxed twice: at the corporate level and at the shareholder (physician) level. In certain circumstances, a dividend may be warranted under the circumstances. While the rate is still 15 percent, physicians should consider a dividend declaration if they anticipate that tax rates could increase in the near future under a new administration and/or Congress. Such planning is more punctuated in the case of a physician’s practice that operates as an "S corporation," where the corporation is mature and has old "C corporation" earnings.

Many taxpayers, including physicians, who own second residences such as vacation homes, have experienced a bit of a roller-coaster effect in the value of their homes. This is particularly true of beachfront and similar resort-type homes. To the extent that values have decreased, it is important that owners determine whether they are entitled to a reduction in real estate taxes. Such taxes are typically very high in resort-type and similar high-end communities.

Second, to the extent possible, owners should be certain that they actually use the home. Mortgage interest is not automatically deductible unless the home actually qualifies as a "residence." This occurs only if the property is used as a residence by the taxpayer within the meaning of the tax law. The law generally states that the property must be used for a period that exceeds the greater of either (1) 14 days, or (2) if rented, 10 percent of the days for which the property is rented at a fair rental.

Finally, if the property is rented, there are other tax consequences. If the property is rented for less than 15 days during the year, it will not be treated as "rental property." In certain circumstances, the rent may not be taxable. If the property is rented for more than 14 days, the rent is taxable, and the related expenses may be deductible, but within certain limits. While the tax consequences are complex, rental of property can significantly reduce the adverse effects of the decline in market value, while helping to pay the mortgage.

Joseph P. Nicola, Jr., CPA, JD, CVA is a tax director with Sisterson & Company, LLP, in Pittsburgh, Pa. He is also a member of the adjunct faculty at Duquesne University in Pittsburgh.