Combatting Capital Gains
What are capital gains?
When an investor sells an investment asset at a profit, the government collects a tax on that profit. That levy is called the capital gains tax. The tax doesn’t apply to unsold investments or assets—it’s collected only when an investment is realized — that is, sold — and only then when it turns a profit for the investor. Assets that are considered “capital” include not only stocks and bonds, but tangibles such as jewelry, coin collections, and real estate.
How much is capital gains tax?
It depends on a couple of factors: how long you owned the asset, and your income bracket. Income brackets are adjusted annually for inflation. For the 2021 and 2022 tax years, the rates are anywhere from 0% to 20%.
No matter when you sell an investment, you’ll owe capital gains. But if you’ve held onto that investment for at least a year and a day, you’ll probably owe less. That’s because short-term capital gains are taxed like regular earned income. Long-term capital gains taxes are lower for all but the highest earning tax payers.
Capital gains taxes in any given year can be offset by losses—that is, when an investment is sold for less than you acquired it for. There’s a maximum limit you can claim in a year, but losses over that limit can be carried forward to following tax years. You may already see where this is going.
Offset Gains with Losses
There is a legitimate way to reduce or even nullify capital gains for a tax year. Tax is only due on the net capital gain. Total capital losses can be applied to reduce that gain. The maximum limit of allowable losses in a given year is $3,000. If your capital profits are equal to or less than that amount, you will not owe capital gains tax. Standing Oak financial is thoroughly versed in how to apply this concept to your advantage.
Professional financial advisors at Standing Oak can also help you avoid running afoul of the IRS wash-sale rule. The rule bars investors from selling an asset at a loss to reap the tax advantage, then turning around and repurchasing the same (or a very similar) investment right away.
It may be tempting to simply hold onto investments indefinitely. If you never cash out, then you’ll never have to pay capital gains, right?
There’s a better way to reap the rewards of your winning investments
Think of it this way: capital gains are the only income where you get to choose when to pay tax. This gives you a lot of control—and a lot of opportunity.
Simple steps first. When selling a security purchased about a year ago, it’s worth checking the exact date of sale. A matter of a few days could mean the difference between paying short-term capital gains or the lower long-term rate. (Another reason to keep track of that paperwork: incurred qualifying expenses in making or maintaining your investment increase the cost basis of the investment, thus reducing taxable profit).
A few days can also make a big difference in using the capital loss method of tax reduction. The wash-sale rule applies to transactions within 30 days or less. After that, it’s perfectly legally to repurchase an investment that was sold at a loss.
Another option is to slowly unwind an advantageous position over a number of tax years. This stretches out the tax consequences. For example, liquidating one third of a position at the end of a tax year, another third during the next year, and the final third at the beginning of the following year would distribute capital gains over three tax years, but only take slightly over a year in real time.
There’s a lot of advantage to be found in nuanced timing of trade sequences. At the end of the year, it’s a great exercise to sit down with your investment advisor and see if you hold any “loser” assets that could be sold to recoup the maximum $3,000 offset, or as close as possible. Savvy investors can hold out for a year with more capital losses before liquidating investments with sizeable capital gains.
The larger the trade and the higher your tax bracket, the more timing manipulation makes an impact.
Keep Excellent Records
Tracking purchase and sale dates on your investments isn’t the only reason to stay on top of that paper trail. If you incur any expenses in making or maintaining your investment, they will increase the cost basis of that investment. Those qualifying expenses can then reduce taxable profit.
Look at the Big Picture
Many investors fall into the “trap of today.” It can be hard to see beyond the current tax year. But it’s helpful to look toward the future and estimate whether and when you may have drastic changes to your income. That’s because your tax bracket significantly determines your tax burden. One example is transitioning into retirement, or gaps between leaving the work force and social security or minimum distribution age of a retirement account. Tax payers in the lowest tax brackets usually do not have to pay any long-term capital gains taxes. So, if income falls into this range during a specific tax year, you could offset a big tax bill by selling assets at a gain that year.
Assuming you don’t need to liquidate all your assets to cover living expenses, you can also donate highly appreciated assets to nonprofits or to your heirs to lessen capital gains liability.
No one has a crystal ball. But if you anticipate that your income will fall in future years, as is often the case when transitioning to retirement, it may be in your best interest to wait to sell assets at a gain to reduce or negate a capital gains tax.
That’s an advanced move called tax gains harvesting.
Tax Gains Harvesting
You know that you can offset capital gains tax by recognizing losses. But within your taxable brokerage account, you can offset investment losses with investment gains as well, and reduce your capital gains exposure. Tax harvesting is when you purposefully await years with less anticipated taxable income to realize investment gains. Retirement is an example of anticipated income change that we covered, but perhaps you may change careers, divest a business, or take a year off to care for family or travel the world. There are lots of reasons income can fluctuate from year to year.
With excellent planning, tax gains can be harvested in low-income years with no missed time in the market. That’s because capital gains are not subject to the wash-sale rule. An investor can claim capital gains and pay low or no taxes if they have no other income, resetting their basis and lowering the relative rates those gains are taxed at. Then they can re-purchase sold stock almost immediately.
Remember that ups and downs in the market while you hold an investment have no tax impacts. It doesn’t matter how long you hold shares or how much they increase or decrease in value. The IRS wants to incentivize investors to weather market volatility.
That’s also why trades within retirements portfolios like 401(k) and IRA accounts are not subject to capital gains tax. Tax is still due of course—that’s a hard and fast rule. But when you owe that tax depends on the type of account—some are taxable upfront (usually by investing with post-tax dollars, as with a Roth IRA), while others come due when liquidated.
Don’t automatically assume it’s better to take a tax impact during your working years rather than after retirement. It’s important to consider the potential impact of a capital gains bump to your tax bracket. You may be knocked out of a low or no-pay bracket after retirement, causing you to incur more tax. Each case is unique to the individual investor.
The most successful tax planning is always that which takes into account the full picture. Each taxpayer will have a unique tax and financial situation which must be taken into consideration when using these tools, not only current but in the future. Understanding marginal tax rate, the rate due on the next dollar of income, and how it will change over time is critical to minimizing tax burden.
Want more great tax intel?
Check out our insights on 1031 exchanges.
Uncertain about your finances, give Standing Oak a call.
Working with your financial advisor consistently over sequential tax years puts you at a huge advantage. Financial planners at Standing Oak develop a deep understanding of each client’s unique situation, putting us in the best position to make recommendations on avoiding or reducing capital gains. Standing Oak Advisors is here to help you navigate the market and your finances. Call us at (714) 410-5251 or email us.
Disclosure: The opinions expressed in this article are not intended to be an investment recommendation or tax advice and does not constitute a solicitation to buy, sell or hold a security or an investment strategy. Standing Oak Advisors and Centaurus Financial, Inc. do not offer tax or legal advice. The views and opinions expressed are for information and educational purposes only.