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Monday, June 17, 2024

How to avoid capital gains tax

Ways to avoid or minimize capital gains tax

05.16.2024

Most people are familiar with the various forms of taxes we pay, including income taxes, sales taxes, and property taxes. But a less commonly understood tax that many of us pay is the capital gains tax, which applies to many of the assets in our investment accounts, as well as physical assets like our home and valuable collectibles. 

Capital gains taxes can reduce the portion of our investment earnings that end up in our pockets, but there are plenty of ways to reduce them — or even avoid them altogether. 

What is capital gains tax? 

A capital gain is something that can occur when you sell an asset — it’s the difference between your adjusted basis (usually the price you purchased it for) and the amount you sell it for. Capital gains taxes are the taxes that apply to these investment gains. 

Capital gains taxes are different from other types of taxes we pay, such as income taxes and sales taxes. First, they are sometimes (though not always) taxed at different rates from our normal income. Additionally, they are specifically triggered when we sell a capital asset for a profit. 

Types of capital gains taxes 

There are two types of capital gains taxes: short-term and long-term. Short-term capital gains taxes apply to the profits on assets you held for one year or less. Short-term capital gains are taxed at your ordinary income tax rate. You’ll pay somewhere between 10% and 37% of your short-term capital gains depending on your taxable income. 

Long-term capital gains taxes apply to the profits from assets you held for more than one year. Long-term capital gains are taxed at a special rate of either 0%, 15%, or 20%, depending on your taxable income. Most people pay either 0% or 15%. Individuals of every income level can expect to pay less in long-term capital gains taxes than short-term ones. 

Types of assets subject to capital gains tax 

Capital gains taxes apply to anything that’s considered a capital asset. These may include securities such as stocks, bonds, mutual funds, etc. These taxes also apply to physical assets, including your home, valuable collectibles, jewelry, personal use items, and more. 

Most assets are subject to the normal short-term and long-term capital gains tax rates, but there are some exceptions. Here are a few examples: 

Asset type 

Maximum capital gains tax rate 

Section 1202 qualified small business stock 

28% 

Collectibles, including coins or art 

28% 

Unrecaptured Section 1250 gains on Section 1250 real property 

25% 

Calculating capital gains tax 

A capital gain is computed by subtracting the adjusted basis of an asset from the selling price. So, if you bought a stock for $1,000 and sold it for $2,000, you would generally realize a capital gain of $1,000. You will owe tax on this $1,000 capital gain during the tax year when you sell the asset.* 

Put simply: Capital Gain = Selling Price – Purchase Price 

Note that tax is only owed on capital gains when they are realized or sold. If you hold onto this stock instead of selling it, you have what’s termed an unrealized capital gain. No tax would be due on the gain until you sold the asset.

The rate of tax that’s due on capital gains depends on how long you have held the asset. If you hold a stock for one year or longer, your gain will be taxed at the long-term capital gains tax rate. But if you hold a stock for less than one year before selling it, your gain will typically be taxed at your ordinary income tax rate. 

If you sell assets throughout the year, it’s important to accurately maintain those records so you can properly report and pay taxes on your gains. Additionally, depending on your income level and the amount of capital gains taxes you owe, you may need to make estimated tax payments, so you don’t owe interest or penalties to the IRS. 

*For illustrative purposes only 

Strategies to minimize capital gains tax 

There are a few steps you can take to either reduce or eliminate capital gains taxes on some or all of your assets. 

Consider your holding period 

The easiest way to lower capital gains taxes is to simply hold taxable assets for one year or longer to benefit from the long-term capital gains tax rate.  

While marginal tax brackets and capital gains tax rates change over time, the maximum tax rate on ordinary income is usually higher than the maximum tax rate on capital gains. Therefore, it usually makes sense from a tax standpoint to try to hold onto taxable assets for at least one year, if possible. 

For example, let’s say you use the Single filing status and have a taxable income of $200,000 and a taxable capital gain of $1,000. If you have held your assets for more than one year, you’ll pay a long-term capital gains tax rate of 15%, resulting in a $150 tax liability. If you’ve held the asset for one year or less, you’ll pay your ordinary income tax rate of 32% — that’s a tax liability of $320. 

Take advantage of exemptions 

While capital gains tax generally applies to all gains arising from the sale of capital assets, there are some exceptions, the most notable of which is the sale of your home. Federal tax law provides a capital gains tax exclusion of up to $250,000 (or $500,000 for married couples filing jointly) on profits from the sale of a home.1 

Keep in mind a few rules for this special exclusion: 

  • It only applies to a home if it is your primary residence. It doesn’t apply to rental properties. 

  • You must have lived in the home for at least two of the past five years. However, you don’t need to have lived in the home for two consecutive years. 

  • You can only take advantage of this exclusion once every two years. 

To accurately calculate how much you’ll owe, determine your cost basis. Consider your purchase price plus the cost of home additions and improvements with a useful life of more than one year you've made along with expenses associated with the purchase and sale of the home. Those items may include closing costs, title insurance, settlement fees, real estate commissions and attorney’s fees. Subtract your full cost basis in the home from the sale price to arrive at your taxable profit. 

Keeping accurate records of your basis can help you when it comes to deducting costs from the sale price of the home and to help lower your capital gain on the home sale. Thorough records could help make a difference if you’re right on the edge of the $250,000/$500,000 exemption threshold. 

Use tax-advantaged accounts 

An easy and impactful way to reduce your capital gains taxes is to use tax-advantaged accounts. Retirement accounts such as 401(k) plans, and individual retirement accounts offer tax-deferred investment. You don’t pay income or capital gains taxes at all on the assets in the account. You’ll just pay income taxes when you withdraw money from the account. 

Since retirement account funds can grow on a tax-deferred basis, the account balances may grow more than if capital gains taxes were assessed. Roth IRAs and Roth 401(k) plans take this one step further — taxes on gains aren’t assessed even when funds are withdrawn in retirement, if certain rules are followed. 

Consider tax-efficient investment choices 

Certain investments are more tax-efficient than others. Opting for these more efficient investments — and avoiding or being strategic about the less efficient ones — can help reduce your capital gains tax burden. 

One example of an asset that's inefficient for tax purposes is an actively managed mutual fund. A mutual fund is a pooled investment with many underlying securities. By investing in the fund, you own a piece of each asset in the fund. 

When a mutual fund is actively managed, it means a fund manager is regularly buying and selling assets within the fund. The capital gains on these sales are passed along to the fund’s investors. And chances are at least some of those assets are creating short-term capital gains, which result in an even higher tax burden. 

A good way to benefit from tax-efficient investment choices is to be strategic about where you hold certain assets. Tax-advantaged retirement accounts allow you to avoid capital gains taxes altogether. To minimize your tax burden, you can hold your most tax-efficient investments in your taxable brokerage account, while holding less tax-efficient assets in your tax-advantaged accounts. 

Tip: Bonds are considered less tax-efficient because of their interest income. Though this interest is subject to ordinary income taxes rather than capital gains taxes, holding your bonds in your tax-advantaged accounts is another action that could save money on the taxes on your investments. 

Use a 1031 exchange for real estate 

Internal Revenue Code section 1031 provides a way to defer the capital gains tax on the profit you make on the sale of a rental property by rolling the proceeds of the sale into a new property. Specific rules must be followed to properly complete the 1031 exchange; you can utilize a qualified 1031 exchange intermediary escrow company for this type of transaction. 

The capital gains tax bill will be paid once the new property is sold. Savvy real estate investors may decide to defer the capital gains on rental property indefinitely by continuing to use 1031 exchange transactions for all their rental property sales. 

Pay less for inherited assets 

The IRS offers a favorable tax treatment for assets you inherit rather than those you purchase yourself. When you inherit an asset, the adjusted basis is generally its fair market value when the previous owner died rather than when they purchased it. 

Here’s an example of how that could help you save money. Suppose your parents purchased shares of Microsoft stock 20 years ago on January 1, 2004 at a per-share price of $27.90. Fast-forward a couple of decades and your parents passed away on January 1, 2024, when Microsoft’s stock price was $400.57. Your adjusted basis in the stock is based on the price at the time of their death, saving you hundreds of dollars in taxable gains for each share. 

Utilize tax-loss harvesting 

This strategy involves selling underperforming investments and booking a loss. You can use these capital losses to offset taxable investment gains and up to $3,000 each year of ordinary income. Unused investment losses each year can be carried forward indefinitely to offset capital gains and ordinary income in future years. 

For example, suppose you realized a taxable profit of $5,000 on a stock sale this year. However, you own a stock that has fallen in value by $2,000 and you don’t expect it to recover anytime soon. You could sell this stock, book the $2,000 loss, and reduce the taxable gain on the other stock to just $3,000. 

It’s important to note that you can buy back the stock you sold at a loss if you wait at least 30 days to do so. If you buy it back sooner than this, the so-called “wash-sale rule” will prohibit you from using the loss to offset the capital gain. 

Read more: How tax-loss harvesting can reduce your tax bill  

Charitable giving 

Investments that have appreciated in value from when you purchased them and held long-term can be donated to charity.  If you itemize, you will receive a charitable donation tax deduction for the fair market value of the investment on the date of the charitable donation. No capital gains tax is assessed on the gain for such investments donated to a qualified charity. 

Conclusion 

Capital gains taxes are an inevitable part of investing. Yes, they can eat into your investment earnings, but they certainly aren’t a good reason not to invest. A trusted financial advisor may be able to help you reduce the amount of capital gains taxes you have to pay. When you’re creating your investment strategy, choose one of these strategies — or, better yet, choose multiple strategies — to help you minimize your capital gains tax liability. 

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1 IRS, “Topic no. 701, Sale of your home,” April 2024 

RO3576510-0524 

Gregory J. King, CPA

Gregory J. King, CPA

Contributor

Greg King is a Tax Specialist at Empower. A Certified Public Account, he is responsible for reviewing and identifying inefficiencies and opportunities for client portfolios, estates, and tax situations.

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