Tax Swap

  

Categories: Tax, Derivatives

If you trade your tax bill with Jeff Bezos, does that mean you get his income too?

Actually, a tax swap doesn't refer to trading tax liabilities with someone else. Instead, it's a maneuver meant to take advantage of a capital loss, even though you want to maintain the loss-inducing investment.

If you take a loss on an investment, you can deduct the loss on your taxes (after all, you have to pay taxes on capital gains, so why shouldn't you deduct the losses?). Unfortunately, to take the loss, you actually have to, uh...take the loss. In other words, you have to sell the investment and book the loss, in order to deduct it from your taxes. A paper loss doesn't count.

So a tax swap involves selling the investment that has the loss, then buying a new investment that's pretty similar (though it can't be exactly the same; the government is onto that trick).

You own shares in a major (legal) drug maker that have fallen in the past few months. You are now $2,000 underwater on the investment, and want to deduct the losses on your taxes. In order to achieve this goal, you sell the shares and lock in the loss. Then you take your capital and buy a drug-maker ETF, which happens to have the stock you just sold as its highest-weighted component.

You didn't sell and repurchase the same stock. You bought a different vehicle with similar exposure. You still have an investment in the sector you had before...plus, now you've got that $2,000 tax deduction.

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Finance: What is a Tax Deduction?102 Views

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Finance allah shmoop shmoop What is a tax deduction Uh

00:06

taxes Love him Hate him You can't leave him but

00:10

you can lower them legally by being you know thoughtful

00:13

about how you spend your earnings All right How do

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we do this Well let's start with the largest tax

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deduction in america the home mortgage And you you the

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dentist who makes one hundred fifty grand a year for

00:26

putting your fingers in wet mouth Well remember that for

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individuals versus corporations we pay a graduated or quote progressive

00:35

unquote tax rate Like almost nothing On the first fifteen

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grand we earned on about ten percent from fifteen to

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thirty grand And then about twenty percent from thirty to

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sixty grand And so on That's progressive So on the

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last twenty grand of earnings you make well you might

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pay say forty percent in taxes and yeah we know

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the numbers own exact We're just illustrating a point Here

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you have a mortgage of three hundred thousand dollars on

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a home you bought for four hundred thousand dollars right

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So you put a hundred grand down and borrow three

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hundred The mortgage costs you six percent per year in

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interest or eighteen thousand dollars to rent that three hundred

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thousand before you owned the home The irs thought of

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you as one hundred fifty grand a year earner but

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one hundred percent of the interest on the home is

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fully tax deductible So what about that last twenty grand

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iii The money you earn from one hundred thirty k

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to one hundred fifty k Well as faras the irs

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is concerned now that you have a home you get

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taxed as if you earned just one hundred thirty two

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grand not one hundred fifty k actually earned Why Because

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that eighteen thousand dollars in interest comes right off the

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top of your earnings See there's the math right there

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one hundred fifty minutes eighteen hundred thirty two taxable earnings

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it's as if you didn't earn that money ever can't

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all right well if you'd had no deductions on that

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last twenty thousand dollars of earnings you'd have paid forty

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percent or eight thousand dollars in taxes But now on

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that last twenty thousand dollars thanks to your mortgage deduction

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well you only have taxable income of two thousand dollars

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And yes you pay forty percent on that two thousand

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Or eight hundred bucks And you mumbled thank you government

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for largely splitting the cost of my mortgage with me

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The american dream is alive and well that's what you

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say Okay And thank you jay There are other deductions

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beyond home mortgages of course but well you get the

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gist here of how they work from a taxpayer's perspective

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Deductions like those from your home mortgages are a good

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thing Common personal deductions also include things like prepaid healthcare

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costs and the cost of feeding quote dependent unquote children

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Aii those noisy things sleeping in your spare bedrooms until

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they're eighteen Okay so those air personal deductions things that

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individual citizens take But what if you're a corporation Well

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in a way it's kind of easier Think of most

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corporations is having a flat thirty percent tax from the

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first dollar they make just keep things simple Participation trophy

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company in kameda one hundred million dollars last year and

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paid thirty million in taxes They netted seventy million after

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tax The company really needs a new trophy smelting machine

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because with so much demand for participation trophies of late

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while the old one is running dullah with mediocrity the

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company spends forty million box on the new machine knowing

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that it will be worthless in ten years either because

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it wears out or because the country gets riel or

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you know simply remembers to you know have a nice

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day participation trophy land Welcome to it They'd appreciate forty

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million dollars in equal parts of four million box each

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year over ten years so that in the next year

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when they again or in one hundred million dollars well

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they now get to deduct four million bucks and appreciation

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from their smelting machine against their hundred million dollars in

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earnings So again as faras the irs is concerned they

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didn't really earn one hundred million dollars even though they

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did They earned quote on ly unquote ninety six million

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and yes they still pay their thirty percent tax Only

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now instead of paying it on a hundred million bucks

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it's paid on ninety six million of earnings or point

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three times ninety six or twenty eight point eight million

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in taxes they did Abducted from their taxes The four

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million box expected value decline from their smelting machine Right

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It goes down four million a year in value from

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the forty they paid They received essentially a credit on

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their taxes of one point two million dollars So instead

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of that year's depreciation costing the company four million bucks

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well it really cost them more like two point eight

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million If you ignore a bunch of other things like

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the original capital cost of the machine what else they

04:45

might have done with that money oven you know via

04:48

smelting machine Think think Corporate jet Yeah those g sixes 00:04:52.774 --> [endTime] are surprisingly tasteful

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