Paying tax is an unavoidable reality of life. While tax dollars may fund important social programs, infrastructure, and services throughout society, that knowledge doesn’t always soothe the burn left behind by a big tax bill. Capital gains tax (tax that is due when a capital asset is sold for a profit) is often one of those unavoidable realities of life.
What if there was a way to help avoid, or at least minimize paying capital gains tax? What if most of the money gained on a smart investment could remain with you, the investor? The good news is that there are a number of ways you can manage and hopefully minimize your capital gains taxes.
This article is going to outline what capital gains taxes are, how they are calculated, and provide you with some valuable information on how to manage capital gains tax. As CERTIFIED FINANCIAL PLANNER™ professionals, we would be remiss if we didn’t point out the limits of our expertise. While we’re up to speed on the complexities of tax law – particularly in this era of new reform – we are not licensed tax professionals. The advice we’re providing in this article is meant to spark thought and discussion between you and your tax preparer.
What is Capital Gains Tax?
Before you start diving deep into information about how to avoid capital gains tax, let’s talk about the details of the tax itself. Simply put, capital gains tax is the tax placed on the money gained from an investment when that investment is sold. Most people will deal with capital gains tax when selling shares of a stock or selling a property, but the tax could also apply to artwork, physical gold, and other collectible items that may be considered investments.
There are two basic ways that capital gains taxes are applied. The first type of investment subject to this tax is a short-term investment. This investment is held for one year or less and, as a result, the gains on the investment are taxed at your normal income tax rate.
The second investment where capital gains tax could be applied is a long-term investment. These investments are held for longer than one year and are subject to a different tax rate than short-term investments. The long-term capital gains tax rates are either 0%, 15%, 20%, or 28% (for collectibles) and the rate applied ultimately comes down to your total income.
Avoiding Capital Gains Tax
Tax avoidance may sound like an illegal activity to some but, in reality, there are a number of perfectly legal and acceptable ways to avoid and/or defer capital gains tax. In fact, the government provides special exceptions for some investments that allow them to grow and be sold without incurring a tax bill. The only catch is that you and your advisors must be aware of the many rules surrounding capital gains tax and implement an appropriate strategy. Again, this is where we find coordinating with our client’s tax professional on strategy proves invaluable.
Here are some methods you can use to cut down your capital gains tax bill:
1. Hold on to Investments Longer
As mentioned, there are two different capital gains tax rates applied to investments based on the length of time that the investment has been held. The long-term capital gains tax rate is much more generous and those of you in the 10% and 12% marginal tax brackets may end up owing no federal capital gains tax at all. All you have to do to take advantage of this benefit is hold your investment longer than 12 months and, if possible, manage your income to stay in the lower tax brackets . This could mean looking to your after tax accounts for cash flow needs (instead of your pretax accounts), bunching your deductions or maximizing tax efficient portfolio strategies. Even if you are unable to stay in a lower tax bracket, the capital gains tax rate for those of you in the 22%, 24%, 32%, and 35% tax brackets is capped at 15% for most investments. A little bit of patience could go a long way come tax season.
This tip does come with one caveat, of course. Holding onto a poor investment for a longer period of time just to try and reduce capital gains tax could backfire in a big way if the investment experiences major changes or losses during that additional waiting period. This is where the adage, “don’t let the tax tail wag the investment dog” comes from. It’s important to consider all costs and benefits of selling or holding an investment before making a final decision.
2. Don’t Forget About Capital Losses
Not every investment incurs capital gains. Some investments may lose money over short or long periods of time and actually incur capital losses. While it’s never nice to see a loss on the balance sheet, these losses can be used to balance out any gains that may be subject to capital gains tax.
As with most investment portfolios, there will be a mixture of investments that perform well and investments that don’t. Many times, you can look at your portfolio near the end of the year (or any other time, for that matter) and identify some investments that have declined in value. If you choose to sell these investments and realize the loss, you will be engaging in what is called “tax loss harvesting.” This is a perfectly legal strategy of realizing losses which can then be applied against capital gains that you may have realized elsewhere in your portfolio. When filing your taxes, you will apply your capital losses against your capital gains to arrive at a net number to place on the tax return. In a year where the capital losses outweigh the capital gains, you can use extra capital losses to offset up to $3,000 of other income. Should capital losses exceed that $3,000 cap, it’s possible to carry those losses forward to offset capital gains in future years . Individual investors can carry over their losses much the same as a corporation can. It’s one of the reasons why Amazon has famously paid no federal taxes in recent years.
Remember that while most of the assets you may own are considered capital assets, those assets that are held for personal use and that are sold at a loss cannot be used to offset other capital gains. Therefore, while you may be able to deduct the loss on a stock or rental house, you cannot deduct the loss of a personal automobile.
3. Eligible Home Sale Exclusion
Many people unnecessarily stress about capital gains taxes that may arise from selling their home. Of course, a home is the biggest investment many people will ever make and losing some money from the sale of a home to capital gains tax can be shocking. The good news is that there are some simple rules that can tell you if your big sale will also come with a big tax bill.
For a home to be excluded from capital gains tax, it must have been your primary residence for at least two years within the 5 years leading up to the sale of the home. You also cannot have excluded the sale of another home within 2 years of your next exclusion. If those two basic thresholds are met, then you can exclude a significant portion of the capital gains on your property from being subject to capital gains tax.
An individual is able to exclude up to $250,000 in capital gains while a married couple can exclude up to $500,000 in capital gains. It’s important to note that those numbers reflect capital gains and not the selling price of the home. This provides a lot of opportunity for growth where homeowners can avoid paying capital gains tax when selling their property.
4. Tax Free Exchanges
Another method of deferring capital gains taxes is to utilize a tax-free exchange. Under certain circumstances, certain types of assets may be “swapped” with similar types of assets without the recognition of capital gains taxes.
While we typically see these tax-free exchanges in investment real estate (under Code Section 1031), under the right circumstances, it may be possible for stock to be swapped under a tax-free exchange as well. The mechanics of utilizing a tax-free exchange are beyond the scope of this article; however, it is important to know that these exchanges remain a viable method of deferring the recognition of capital gains taxes until the replacement asset is sold at some point in the future.
If you are considering utilizing a tax-free exchange, do your research first, and contact your tax professional. Most tax-free exchanges have to be completed within a limited time frame and satisfy a number of requirements.
5. Try New Methods of Portfolio Rebalancing
Portfolio rebalancing is a common practice for investors and involves regularly assessing the performance and asset allocation of a portfolio, then rebalancing the portfolio to ensure it is in line with the original intended targets. One of the most common ways portfolio rebalancing is done is by selling high performing assets that have grown to a disproportionate size within the portfolio and then buying other assets to complete the rebalancing process.
Of course, the downside to using this method for portfolio rebalancing is that selling high performing assets could incur capital gains tax. One way you can avoid capital gains tax is to try rebalancing your portfolio without selling off top performing assets. Instead, for example, you could choose to use dividend income to buy new investments in an effort to complete the rebalancing process. If this can be done successfully, no high performing stocks should have to be sold and, as a result, no capital gains tax will be incurred.
6. Consult With a Professional Advisor
Keeping up with the many rules and laws surrounding capital gains taxes can be a challenge. Not to mention, the rules can and do change as the government of the day implements their policies to try and affect change.
One way for investors to make sure they are doing everything they can to avoid paying capital gains tax is to enlist the expertise and support of a professional advisor and tax professional. These advisors can work together to help create plans for reducing capital gains tax and ensure that their strategy is up-to-date with the current laws and regulations.
It All Begins with a Plan
Learning how to avoid or at least minimize capital gains tax is just one part of the equation. Now, investors have to put a plan into place to ensure that their strategy meets their investment goals while also being tax efficient. Proactive, holistic long-term planning like this is what we do with our client families every day. Wondering what a plan could do for you? Let’s talk.