Minimize capital gains tax
Thursday, March 31st, 2011
When you sell an asset for more than your investment in it, the IRS says you must pay tax on the difference, called capital gain. For some years, the tax rate on such gains has been lower than regular rates if the asset is held for a long term (currently, more than one year). Hence the nickname, capital gains tax. The asset may be stocks, bonds, mutual funds, other assets such as equipment and real estate, or an entire company.
On the tax return, short-term and long-term capital gains and losses are accumulated in a specific manner to arrive at net short-term and long-term capital gain or loss from which the tax is calculated.
With good planning, there are several methods that you might use to minimize capital gains, and thereby minimize the tax you must pay on them. Here are six tips (with nods to Alan Haft, CPA Insider):
- When selling stock, specify which shares to sell. By choosing, you can decide the amount of gain or loss on the sale. This method can be used in conjunction with other sales to exercise some control over the net capital gain or loss amount reported on the tax return.
- Make all gains long-term. In 2010, short term capital gains are taxed at your ordinary income tax rate, which can be as high as 35% depending upon your income level. Long-term capital gains are taxed at a maximum of 15%, with additional breaks for lower-income taxpayers. So by holding onto your assets at least one year before selling, you take advantage of the lower tax rate on long-term gains.
- Use capital losses to offset capital gains. Short-term and long-term capital losses reduce their respective gains dollar-for-dollar. If you have more capital losses than gains, the net loss can reduce other income. This loss utilization is limited to $3,000 per year, but the excess loss can be carried forward to future years.
- Replace losing investments. If a stock or fund investment is depressed, you may sell it to lock in a tax loss. If you still believe it’s a good investment, wait 30 days before buying into it again to avoid the “wash-sale” rule. If you buy an identical stock within a period 30 days before or after the sale, the wash-sale rule prevents you from claiming a loss on the sale.
- Replace winners. The wash-sale rule does not apply when you sell an investment to lock in a gain. You may sell it and then buy it back immediately. You might do this if you have a loss to offset the gain, reducing the tax bill on the sale. When you buy the stock back at the higher price, you will pay less tax on future gains because your basis (the cost of the investment) is higher.
- Check mutual fund’s tax efficiency. If you invest in mutual funds, check a fund’s tax-efficiency ratio before investing. This is the percentage of total return you keep after taxes.
Another mutual fund idiosyncrasy is capital gains distributions. Funds may realize capital gains when they sell their underlying investments. During the financial meltdown, we saw large taxable capital gain distributions on 1099s even as mutual funds were losing value. Fund managers were forced to sell appreciated investments in order to redeem shares as investors pulled out of the funds. The resulting capital gains were distributed to all investors, who faced potential tax liability even though they remained fully invested and received no cash from the funds.
Tax impact is not the only criterion behind investment decisions, but it can play a part. By consulting with your CPA or an investment advisor familiar with tax implications, you can balance all factors to make the best decisions. Minimizing capital gains tax can be complicated, but with good planning, it can help you keep your money in your pocket and out of Uncle Sam’s.