Capital gains tax doesn’t have to overshadow your profits.
Capital gains are profits you see from the sale of assets and investments, such as stocks and bonds or real estate. Any capital losses you experience each year are offset against these gains.
Capital gains tax is the tax you must pay to the IRS on profits made after the sale of these assets, and may apply regardless of your tax bracket. This type of tax is capped at 20 percent, but you can end up paying more if you’re not careful.
You’ll first need to figure out your capital gains by determining the adjusted selling price. This is calculated by determining the cost of the sale, including commissions, and your basis, which is the purchase price, sales, tax, improvements etc., and subtracting it from the sale price. This difference is the capital gain.
This is important to remember, since many people think they’re going to be taxed on the full sale price of an asset; for example, the sale of a house.
Here are strategies you can use to reduce or avoid capital gains tax:
Wait longer than a year to sell
Short-term gains are those from property held within a year, and the tax rate is what you pay for income tax. Long-term gains are from property held over a year, and tax is generally less than the short-term gains tax.
So, if you hold off on selling longer than a year, until your gains will be considered long-term, your tax rate will probably be lower than your marginal tax rate.
Leverage capital losses
As mentioned above, capital losses offset capital gains in a given year. Thus, if you time these out to complement each other in the same year, you can reduce your capital gains tax. Be aware of limits, however. All capital gains have to be reported, but you can only take $3,000 of net capital losses each tax year. Any additional losses may be carried over into the future years.
Tax-engineered products for stock sales
You can convert stock gains into cash with tax-engineered products, thus protecting those gains and deferring tax. This avoids the tax you would be required to pay if you sold them outright.
Stock loan programs and stock collars, or hedge wrappers, allow you to borrow against your stock; variable prepaid forwards let you to sell your shares in the future in exchange for payment now; and swap funds enable you to diversify your portfolio by making tax-free exchanges of assets into partnerships with other investors.
The charitable trust for real estate or securities
Another way you can avoid tax – on real estate, businesses, or securities – is with a charitable trust. How it works: you will split your assets into two different portions. One will be your income for your lifetime or up to 20 years, and the rest will be given to charity.
The charitable remainder trust (CRT) is the most common type. Another beneficiary, or other beneficiaries, will establish the trust with you, and you can put your mutual funds, stocks, or real estate into the trust. This gives you a deduction right away that is equal to the value of the remainder interest you have to give, and your age, income interest, and the current section 7520 rate from the IRS each month determine how it’s calculated.
A big benefit is that the gift you make is no longer part of your taxable estate. Appreciated assets are sold by the trust, and there’s no tax due on your capital gains. The assets are then reinvested by the trust in a diversified portfolio.
You will then be paid from the trust – either via a percentage of the assets in the trust or a specific dollar amount. Anything left over in the trust goes to charity when you die.
A charitable lead trust, on the other hand, gives income to the charity, and the remainder goes to you and your beneficiaries.
Note the PEP and Pease limits
Gains that reach above certain thresholds of adjusted gross income (AGI) can see certain limits – the personal exemption phaseout (PEP) limit reduces personal exemptions, and the Pease limit caps itemized deductions. These limits phase out tax breaks like medical deductions, child tax credits, American Opportunity and Lifetime Learning Credits, and the rental real estate loss allowance.
These limits can also increase your provisional income to determine what your tax will be on Social Security benefits. These break phaseouts force you to recapture some of the depreciation on your assets you’re selling, and recaptured depreciation tax is 25 percent for depreciation and real estate.
One of our focuses at Provident CPAs and Business Advisors is ensuring our clients pay as little tax as legally possible. Contact us today to learn about our tax minimization services.