Many folks groan when they hear the phrase “capital gains.” While it indicates you have made money from the sale of an asset or real estate, it also means you will be taxed on that gain. Unfortunately, taxes are unavoidable, but fortunately, there are ways you can minimize your tax liability. Here are four strategies that may keep the IRS from taking a larger chunk out of your capital gains.
1. Contemplate Tax-Loss Harvesting (TLH)
Losing money on your investments is usually a bad thing, but utilizing a tax-loss harvesting strategy means you can claim capital losses to offset your capital gains and still reinvest the proceeds to maintain market exposure. If you show a net capital loss, you can use the loss to reduce your ordinary income by up to $3,000 (or $1,500 if you are married and filing separately). Losses above the IRS limit can be carried over to future years. Sometimes it is advantageous to sell depreciated assets for this reason. A tax-loss harvesting strategy can help minimize your tax liability and keep more money in your pocket. However, trying to reduce taxes shouldn’t come at the expense of maintaining a thoughtful asset allocation in your portfolio.
2. Tax-Efficient vs. Tax-Inefficient Investments
Some investments can be more tax-efficient than others. For example, a municipal bond is considered tax-efficient because the income from municipal bonds are federally tax-exempt and may be state tax-exempt. Investments like high-yield bonds are considered less tax-efficient because the interest payments are not tax-exempt, meaning they are taxed as ordinary income rates.
Like assets, there are investment accounts that are more tax-friendly. Tax-advantaged accounts allow you to defer paying taxes on the gains or earnings to a later date. For example, a traditional IRA or a 401(k) will allow you to contribute using pre-tax income and withdrawals are taxed when you retire, when your income is typically lower.
Pairing tax-advantaged accounts like a 401(k) with tax-inefficient assets like a high-yield bond and pairing taxable accounts (individual, joint, trust, etc.) with more tax-efficient assets will create a more optimal mix to minimize tax liability. Placing investments that have higher tax rates with accounts that delay taxes will help reduce the amount you owe. Since you are not expected to pay federal taxes on something like income from a municipal bond, there is no use placing it in a tax-advantaged account because there are no taxes to delay.
Of course, this is a bit of an oversimplification as there are many nuances that can make certain investment vehicles more tax-efficient than others. For example, although REITs are at the bottom of the chart, there are still plenty of advantages to investing in them. Dividends from REITs are sheltered from corporate tax, and some dividends are considered a return of capital that isn’t taxed at all. This is why it is imperative to work with an experienced professional who can use the nuances of each financial instrument to your advantage.
3. Timing Matters
Timing the sale of your investments is critical to lowering your capital gains taxes. Selling your shares after holding for less than a year will result in a short-term capital gains tax. This means that all the gains you made from the sale of the stock will be taxed at your ordinary income rate, which can be 32%-37% for high-earners. Holding on to an asset for more than one year will be taxed at the long-term capital gains tax rate, which can be 0%, 15%, or 20%.
Holding periods are also critical when it comes to the sale of real estate. If you sell your primary home and you lived in the home for at least two years of the five-year period before the sale, the IRS allows you to exclude the first $250,000 of capital gains (or $500,000 for a married couple filing jointly). While the capital gains exclusions do not apply to investment properties, you may be able to utilize like-kind exchanges to defer capital gains tax by reinvesting in other real estate.
4. The Difference Between Cost Basis & Share Lots
When you buy any amount of stock, the stock is assigned a lot number regardless of the number of shares. If you have made multiple purchases of the same stock, each purchase is assigned to a different lot number with a different cost basis (determined by the price at the time of each purchase). Consequently, each lot will have appreciated or depreciated in different amounts. Some brokerage accounts use first in, first out (FIFO) by default. If you utilize FIFO, your oldest lots will be sold first. Sometimes FIFO makes sense, but not always. Sometimes it is ideal to sell lots with the highest cost basis, which is commonly done as part of a tax-loss harvesting strategy.
Passing on assets as an inheritance can also increase your cost basis. Assets passed on to the next generation at the time of death allow your heirs to pay tax only on capital gains that occur after they inherit your property, through a one-time “step up in basis.” For example, when one spouse dies, assets passed on to the surviving spouse will have a cost basis of the price of the asset on the day in which they passed. This eliminates the deceased spouse’s portion of capital gains.
We’re Here to Help
Minimizing capital gains taxes is only one component of your financial well-being. After all, having to pay capital gains taxes is a positive sign that your investment strategies are doing well. At Wilkinson Wealth Management, we build your investment portfolios based on your goals and objectives. We start by gathering information and clarifying your objectives to ensure your investments are aligned with your goals, time horizon, and risk parameters, among other considerations. To learn more, call 434-202-2521 or email susan.wilkinson@lpl.com to schedule an appointment.
About Susan
Susan Wilkinson is founder, president, and financial advisor at Wilkinson Wealth Management, a financial services firm in Charlottesville, Virginia, providing customized financial planning and strategies with a personal approach. With over 25 years of experience, she has a passion to come alongside her clients to help them fulfill their dreams and grow their wealth so they can be financially independent. Susan is known for listening to her clients, digging deep into their values, concerns, needs, and goals so she can build a financial plan tailored to their unique life. She prioritizes building long-term relationships with her clients and being the person they call when life throws a curveball or questions arise.
Susan is a CERTIFIED FINANCIAL PLANNER™ professional and has an MBA from Webster University and a Bachelor of Liberal Arts in Economics and Sociology from the University of Mary Washington. When she’s not serving clients, you can find Susan outside, either gardening, biking, or hiking. She’s a homebody at heart who loves music, especially playing the piano and cello. One of her favorite things to do is spend time with family, including her husband, Terry, her children, and her twin granddaughters, whom she affectionately (and appropriately) calls the “twinados.” To learn more about Susan, connect with her on LinkedIn.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained.