Large capital gains are always something worth planning for. Especially after selling a business, tax years with large capital gains can feel particularly painful when the tax bill comes. Even though long-term capital gains are taxed at more favorable rates, there are still many planning opportunities to reduce the taxes even further.
Capital Gains
When you sell an investment for more than you bought it for, there is a potential for capital gains tax. While some investments do not necessarily need to be purchased, as is the case with stock grants in a company, or starting your own company, when sold, they hopefully exceed the “cost basis” of the investment. In other words, you got out of the investment more than you put into it. While this is the core goal of investing, there are associated taxes that must be addressed.
Investments subject to long-term capital gains tax can fall into one of three federal tax brackets. If your taxable income is below $48,351 for single filers and $96,700 for joint filers, there is no capital gains tax due. After that, a 15% tax rate applies for taxable income up to $533,400 (single) or $600,050 (joint). Anything over that is taxed at 20%. Once you reach $200,000 (single) or $250,000 (joint) in Adjusted Gross Income, there is an additional 3.8% Net Investment Income tax as well. For example, $1,000,000 in long-term capital gains from a stock sale would top the 23.8% bracket, and would still be preferable to the top 37% federal income tax bracket.
However, with the proper planning, there could be room to reduce the tax rate below 23.8%, depending on the plans for the money. It is important to understand, though, that some strategies allow you to simply defer your capital gains as opposed to reducing them. For example, if there is a strategy that would push all $1 million in capital gains to a future year, that does not necessarily mean you are saving on taxes, more so that you deferred the same tax liability to a future year. If capital gains rates drop before that future year, then yes, that strategy did ultimately reduce taxes. Here are 5 strategies that may help manage capital gains more efficiently:
1. 1031 Exchanges
Let’s say you sell a rental property and generate capital gains. The goal of 1031 exchanges is simply to purchase a similar property and transfer the capital gains to the new investment. It’s essentially like swapping properties without triggering a taxable event. This can be very helpful for real estate portfolios where the plan is to reinvest proceeds back into real estate anyway. This allows you to defer the taxes until you are ready to cash out funds to move to another asset class (like cash, stocks, business investment, etc.).
2. Tax Loss Harvesting and/or Direct Indexing
Stock in a brokerage account can include tremendous amounts of concentration risk. Using strategies like tax loss harvesting or direct indexing can help diversify the risk without immediately taking a large tax hit. For example, someone with $1 million in stock from a company like Apple or Tesla could contribute the $1 million into a direct indexing strategy that would buy all the stocks of a given index, like the S&P 500. Over time, the investment would automatically harvest losses by selling stocks that go down and buying stocks that go up. If done correctly, the strategy over a couple of years will eventually create the same capital gains problem that you started with. However, taxpayers would have roughly deferred the taxes over multiple years while holding a much more diversified position compared to the original concentrated stock.
3. Qualified Opportunity Zones
For those attempting to enter real estate, moving proceeds with high capital gains into real estate properties within Qualified Opportunity Zones (QOZs) could be a great start. Somewhat similar to the 1031 exchanges, these physically designated zones in America can reduce your capital gains tax if held over multiple years. After 5 years, capital gains can be reduced by 10%, and after 7 years, the reduction increases to 15%. This could be a great solution after selling a business, since business owners may be looking to diversify their overall investments anyway.
4. Charitable Giving and/or Donor-Advised Funds
For those who know that charitable giving is a priority for them, donating assets with high capital gains can be a great idea. Instead of donating cash and claiming a charitable deduction, many times the same donation can be achieved by giving appreciated stock instead. To make matters better, a donor-advised fund can help take advantage of the tax benefits of charitable giving without being forced to give it away at the same time. DAFs will generally let you claim the same charitable deductions as giving cash or appreciated assets, but allow owners to hold the contributions into the fund until you are ready to distribute them.
5. Timing Gains
Sometimes the easiest path is just spreading out the gains over multiple years. Since generally anything over $600,000 for a married couple will likely be taxed at 23.8%, it could be wise to sell $250,000 of gains over 4 years as opposed to $1,000,000 in one year. This could be achieved through an installment sale of a business or simply selling off portions of appreciated stock each year. Especially in years when you know income will be higher or lower, such as the year after selling your business, this can be especially helpful.
Tax Planning
Moving investments around for tax benefits should always come back to the original purpose. Locking up funds for a decade simply to remove some taxes, when those funds could be reinvested better somewhere else, is always a tough balance. Focus on building the financial foundation you want and then work around the edges to benefit from a tax perspective. It is great that an investment made money, but now you have to pay the taxes associated with it. High capital gains are usually a double-edged sword, so use a strategy that fits into your overall goals and plans.
TC Falkner 