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R. Klein, EA
R. Klein, EA, Accountant
Category: Finance
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Experience:  Intuit Ask a Tax Expert. QuickBooks Certified Pro Advisor (all editions)
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Ok, I asked a similar question previously, but Im still a

Resolved Question:

Ok, I asked a similar question previously, but I'm still a little confused. Basically, my goal is to avoid taxes on capital gain. The idea is to create a company (sole proprietorship) and deduct the expenses related to the investment activity from the capital gain, in order to reduce taxes (ex: I gain in interests $500 / month, I deduct from it part of phone and internet bills, office expense (I have an office just for investing), and transportation, and end up with a "net profit" much lower).
Can I legally do that? Thank you.
Submitted: 1 year ago.
Category: Finance
Expert:  R. Klein, EA replied 1 year ago.

R. Klein, EA :

Hello. I will try to assist you today.

R. Klein, EA :

What type of capital gain are you trying to avoid taxes on?

Customer:

I invest in stocks, bonds, and p2p loans.

R. Klein, EA :

one moment please

R. Klein, EA :

First, interest is not a capital gain.

Customer:

ok, sorry, language bundle I guess, it happens to me with english :)

Customer:

so I mean: avoid taxes on interests gained from capital

R. Klein, EA :

I am sorry. I only speak English.

Customer:

english is fine.

Customer:

I didn't expect you to speak French

R. Klein, EA :

Are you familiar or know the difference between US capital gains and other types of income?

R. Klein, EA :

I don't want to explain this over your understanding

Customer:

No. But if it matters, I am only interested in taxation applied to interests from short-term (1 year) to long term (8 years) investments

Customer:

so if this is not capital gain, then I do not need to worry about capital gain I guess.

R. Klein, EA :

Interest is the money you earn from loaning money to others.

R. Klein, EA :

CApital gain is the difference between the purchase of a security and the sale of the same security.

R. Klein, EA :

They are not treated the same.

R. Klein, EA :

for US tax purposes at least

Customer:

oh. subtle difference... ok.

R. Klein, EA :

short-term capital gain applies to investments held a year or less.

R. Klein, EA :

long term requires a holding period of one year plus a day or longer

Customer:

great, I'm learning a lot :)

Customer:

so I would be mostly in the category of "long-term" and "interests".

R. Klein, EA :

In any case, capital gains can ONLY be offset by capital losses or vice versa.

R. Klein, EA :

You cannot use a capital loss to reduce Ordinary Income.

R. Klein, EA :

Interest is Ordinary Income. Therefore you cannot offset interest with capital losses.

R. Klein, EA :

Interest falls also into a second category called PASSIVE income. Wages or a small business are NON-PASSIVE income.

R. Klein, EA :

You cannot use one to offset the other in these categories either

R. Klein, EA :

You cannot use your household expenses to offset either interest or capital gains.

Customer:

I am not talking about household expenses, but about a company expenses.

R. Klein, EA :

A long term gain can be offset only by a long term loss, for the most part.

Customer:

there are investment companies, and I would bet my life that they play with taxes.

R. Klein, EA :

Your company expenses cannot offset interest or capital gains or vice versa

Customer:

even if the activity of the company is to invest money?

R. Klein, EA :

I wouldn't place such a bet.

R. Klein, EA :

Do you mean a company that you own that only invests for your personal benefit?

Customer:

so you are saying that all the banks, all the trading companies, all the fortune management companies, they cannot write off their functioning expenses from their taxes, and they are taxed on their gross income and not their net income?

R. Klein, EA :

No. That is not what I am saying.

Customer:

I mean: a company that I own, and that invest, among others, for my personal benefit. I could/would manage other's people money. and the expenses I w ant to write-off are directly linked to this activity, I am not talking about regular household expenses.

R. Klein, EA :

You say "I have an office just for investing" . I am assuming you mean you have an office at home that you use to manage your personal investments.

R. Klein, EA :

Are you a licensed financial advisor?

Customer:

I have an office, not at home (separate), that I rent for the sole purpose of investing.

Customer:

It is therefore an expense, that I should reasonably be allowed to deduct from the gross income.

R. Klein, EA :

That would not be considered a deductible "business" expense. You are not in a business for profit in that situation.

R. Klein, EA :

It is not considered such an expense, no.

R. Klein, EA :

Under US tax law you would be not allowed to deduct that type of expense for your personal investing.

Customer:

so basically, it is not considered a "business" to work on buying and selling financial products?

R. Klein, EA :

Now, if you are a TRADER as defined by the IRS, then it WOULD qualify and different rules apply.

Customer:

so what you're saying is that trading and selling loans cannot be done under sole proprietorship and requires specific licenses?

R. Klein, EA :

How actively do you invest? Do you make hundreds of trades? Are you trading to gain profits based on the very short-term swings in the price of a stock or are you investing for ling term and wanting dividends, etc.?

R. Klein, EA :

<long>

Customer:

I invest mainly in loans (p2p) and invest daily, it means hundreds of transactions per year, and it is long term (over a year)

R. Klein, EA :

Do you do this type of trading as the sole means for your income? Or is this a side activity?

Customer:

sole mean of my income

R. Klein, EA :

I would recommend that you visit a website dedicated to trading as a business activity. It's called www.traderstatus.com

Customer:

I thought that trading wasn't considered the same as interests from a loan

R. Klein, EA :

On that site they discuss they heavy burden you will need to prove to show the IRS what you are doing is a business and not an investment activity

R. Klein, EA :

You are getting into a very gray area of the law. For the most part, the decisions from the IRS are stacked against you.

R. Klein, EA :

It is not an impossible hurdle to prove you are in a business, but it is presumed that you are not operating a business.

Customer:

isn't having no other income enough?

R. Klein, EA :

The biggest problem you have in deciding that you want to be running a business is that there are special accounting rules that will apply. One of those has to do with income earned being taxed as ordinary income rather than the more favorable capital gains.

R. Klein, EA :

Imagine you have a business that buys a security for 100K, then you sell it 2 years later for 110K.

R. Klein, EA :

As a business, you would owe tax on the ordinary income of 10K. As an investment you pay tax on a capital gain. The difference in tax could be as much as $2500.

R. Klein, EA :

The upside is you can deduct your ordinary business expenses against that higher tax. The bad news is that the expenses may be less than the tax savings as a capital gain.

R. Klein, EA :

Once you elect to be taxed as a business, you cannot flip-flop back and forth based on your tax situation for the year. You would be locked into your choice for at least a year at a time.

Customer:

I do not really care how I am taxed, as long as I can deduct expenses. The cost of rent, transportation and financial services alone is tremendous and would outweight any difference in taxes calculation if I can deduct it from the profit.

Customer:

so whatever I can do to deduct expenses, I am willing to do it ,even if it "increases" my tax rate in a certain bracket.

R. Klein, EA :

Well, overall, I cannot make a judgment in your particular case, at least not here online. There are many factors that would go into that decision.

R. Klein, EA :

I would recommend you visit with a local CPA or EA (tax professional) who can go over all the facts of your case to help decide what your situation is.

Customer:

ok. I guess it is more complex than expected. Thank you for your time, I took a lot of it

R. Klein, EA :

To summarize, the general rule is you would not be able to deduct the expenses, but there are facts and circumstances where a different approach is warranted.

R. Klein, EA :

Yes, it IS a complex issue.

Customer:

ok, thank you. I'll dig further.

Customer:

have a good one

R. Klein, EA, Accountant
Category: Finance
Satisfied Customers: 2923
Experience: Intuit Ask a Tax Expert. QuickBooks Certified Pro Advisor (all editions)
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