Strategies to sidestep capital gains taxes

Strategies to sidestep capital gains taxesNothing takes a bite out of investment gains like a capital gains tax.  Unfortunately, investors consistently under-estimate the amount of capital gains taxes that can be owed when they choose to sell an asset.  With Federal capital gains rates as high as 23.8 percent (20 percent plus a 3.8 percent surtax for high wage earners) and state capital gains rates where applicable, it is easy to see the importance of understanding the full impact of taxes on your investments prior to a sale.

Under certain circumstances, the sale of everything from a business and personal property to non-retirement investments and real estate could trigger capital gains taxes.  For example, if you had purchased an investment for $10,000 and later sell that investment for $15,000, you may realize a $5,000 gain.  In addition to calculating the gain, it is important to be aware of the period of time the asset was held as it too, impacts the tax.  Federal short-term capital gains (assets held less than one year) are taxed at ordinary income rates while long term capital gain rates (assets held for greater than one year) are taxed at lower, more favorable rates.  In fact, According to Dawn Connolly, CPA of “A taxpayer in the 15% tax bracket may be able to pay no tax on capital gains and qualifying dividends.”  In some cases, careful planning can help investors reduce or even sidestep these taxes altogether.

Offset gains against losses

Tax-loss harvesting is the process of selling assets or investments (non-retirement) that are valued at less than their cost basis in order to realize a loss.  (The cost basis is the amount you paid for tax purposes adjusted for reinvested dividends, stock splits, etc.) This loss can be used to offset other investment gains or $3,000 per year of losses can be used to offset ordinary income if no gains exist.  (Excess losses can be carried forward and/or gradually written off against income each year).  While most investors would prefer not to lose money on any investment, if loses do exist, they can help offset other gains.  Keep in mind that purchasing a substantially identical investment 30 days before or after the sale could trigger the wash-sale rule, resulting in the IRS preventing you from claiming a loss.

Timing your gains

You may be asking how selling an investment to take a capital gain can be helpful. For 2017, if you earned $75,900 or less and you are married filing jointly, or $37,950 if you are a single filer, you may be eligible for a 0% long-term capital gain rate.  If your income has suddenly declined or is expected to decline you may want to consider timing the sale during a year when taxes may be minimized or reduced.  While there are no wash-sale rules that prevent selling investments for a gain and buying them back immediately, realizing gains can impact the taxation of social security and various deductions and tax credits, as well as state income taxes. 

Timing gains with a relocation may also be considered if you are moving from a state that imposes a high capital gains rate to a state with lower rates.  According to the Tax Foundation, the states with the worst total capital gains rates (including state taxes) are California, New York, Oregon, Minnesota and New Jersey.  Timing the sale of assets after relocating from a higher capital gains state to one with less or no capital gains rates has the potential to reduce capital gains.  Also be sure to coordinate the realization of capital gains with other financial strategies you may be considering including any Roth conversions.  Bottom line – harvesting gains up to the maximum 0 percent threshold can provide tax savings for some taxpayers.

Improve tax efficiency of portfolio

The measure of how often assets are bought and sold within a portfolio is referred to as "turnover" and the frequency of these changes can have a huge impact on investment taxes. Simply put, the more adjustments that are made to your investment portfolio, the more potential tax liability that you could be exposed to, even triggering the dreaded short-term capitals gains treatment for investments held less than one year.  Reviewing the turnover of your overall portfolio and each of your investments may help improve overall tax efficiency.

Another approach to improving the tax efficiency of your portfolio is simple – maximize tax deferred savings accounts prior to utilizing taxable investments.  The sale of investments within 401(k) plans, IRAs, Roth IRAs and other tax deferred accounts will not be taxable.  While pre-tax retirement account distributions may be taxable as ordinary income, deferring these taxes until later can be beneficial. 

Avoiding capital gains on real estate

In addition to some of the approaches noted above, making a property your primary residence for 2 out of the last 5 years may qualify the property for a $250,000 capital gain exclusion ($500,000 for married couples).  Keep in mind that there is a two-year waiting period if you took advantage of this during the previous two years.

Real estate investors or business owners also have an opportunity to defer taxes on their sale through the use of a 1031 exchange.  Typically, anytime you sell a business or investment property for a gain, you have to pay tax on the gain at the time of sale. According to the IRS, IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. While gains deferred in a like-kind exchange under Section 1031 may be tax-deferred, they are not tax-free and simply defer taxation until a later date.  1031 exchanges are complex and should be carefully reviewed with your accountant and attorney. 

Charitable donations

For investors that are planning to support a qualified charity, gifting highly appreciated assets may be beneficial.  Since a qualified charity will not pay capital gains when selling a donated asset, strategically donating assets that would realize capital gains taxes rather than a cash donation should be considered.  This can be an effective way of giving back while also maximizing your net worth.   

Stepped-up basis

While tax laws are subject to change, it is currently possible to avoid capital gains by passing appreciated assets at death.   Since assets are “stepped-up” to the value on the date of death, capital gains may evaporate all together when you pass away.  For example, let’s assume that an elderly parent leaves an investment portfolio to their children that is valued at $500,000 on the date of death with a cost basis of only $100,000. While beneficiaries may have to pay estate or inheritance taxes depending on the size of the estate, they will not be responsible for capital gains tax on the $400,000 of capital gains.  Choosing to pass certain highly appreciated assets at death can reduce capital gains for your beneficiaries.

Keep in mind that it is not advisable to hold onto unsuitable investments simply to avoid taxes and there are other considerations that should be reviewed including the overall benefits and risks of your portfolio.  Consider reviewing IRS publication 544 – Sales and other Dispositions of Assets for more information.  There is no substitute for individualized tax advice and since everyone’s situation is unique, consider speaking to your tax and legal advisers to determine the most appropriate approach for you.