- The third basic tax strategy is to change
the character of the income, which can then
change the rate at which the income is taxed.
Tax payers wish income to be classified as
long-term capital gain income, which is
usually taxed at a lower rate than is ordinary income.
Remember, ordinary income comes from working for an
employer, owning and operating your own business,
earning interest on a bank account, and so forth.
It's ordinary.
Capital gains income is income earned from
buying an asset low and selling it high.
Simple examples are stock investments or real estate
investments that increase in value.
The capital gains income is the
amount of the value increase.
With ordinary income in the United States,
the tax rates depending on the level
of income range from 10% to 37%.
However, again in the United States, long-term
capital gains income tax rates vary depending on
your overall level of income from zero to 15%,
or sometimes as high as 20%.
The key point is that long-term
capital gains tax rates are lower.
Okay, so how do I convert ordinary
income into long-term capital gains?
Well the most common technique is to make sure that you
hold or keep appreciated assets, such as stock investments
or real estate investments, for more than one year.
If you buy shares for $1000 and sell them for $1400,
that $400 increase is a capital gain, and it's taxed as
ordinary income if you sell the shares within one year.
If you wait for more than a year to sell the shares,
the $400 capital gain income is taxed
at the lower capital gains rates.
How about more complex techniques to convert ordinary
income into long-term capital gains?
Well the short answer is that you and I are almost certainly
never going to be involved with these complex strategies.
The longer answer is that this is where
subtle tax shelter arrangements arise.
Here are a couple of examples.
Carried interest is a compensation arrangement
in which an investment fund manager is paid
in the form of additional shares in the fund
rather than with a straight salary.
If and when those shares go up in value, this income
is taxed at capital gains rates, not as ordinary income.
Another example of a strategy to change the character
of income is called ISOs, or Incentive Stock Options.
The idea is similar to the idea of carried interest.
Employees are paid with incentive stock options
rather than with a straight salary.
Employees hold the ISOs, the options.
When they eventually exercise the options and then
sell the shares purchased in the option exercise,
the excess of the share selling price over the
option exercise price is taxed as a long-term capital gain
at the lower capital gains rates.