With the Dow Jones and S&P 500 having reached all-time highs during the course of 2019, many investors currently face a good problem to have… how to manage capital gains in their taxable portfolio in a tax-friendly manner? As many securities appreciate in value over longer periods we should know that eventually, we will have to pay taxes when we sell the securities. The question then becomes, what are some strategies to lower the capital gains hit?
What is a capital gain? Capital gain is a rise in the value of a capital asset (investment or real estate) that yields a higher value than the original purchase price. The gain remains unrealized until the asset is sold.1
The first thing that an investor should consider is, have they held the security (such as a stock, mutual fund, or bond) long enough to qualify for long term capital gains treatment? If you purchase and hold a security for one year and a day, it will qualify for long-term capital gains treatment when you sell the security. This is a good thing because the tax laws provide a preferential tax rate of either 0%, 15% or 20% on long-term capital gains property, depending on your overall income. If you sell the security before qualifying for the long term preferential tax rate, you have a short-term held property and will subject the capital gains to your ordinary income tax rate which could be as high as 37% under current law.² So to the extent possible, it is always best from a tax standpoint to sell securities when they have qualified for long term tax treatment.
Another important consideration on how to limit the tax burden of selling securities for a capital gain is one of timing. If we are faced with the choice of paying tax on $50,000 of capital gain in one year or spread out over two years, often it can make strategic sense to spread the taxable capital gain over a longer time period (perhaps several years or more depending on the situation and magnitude of income involved). An increase in capital gain income, especially larger amounts, can push someone into a higher tax bracket and put a strain on cash flow when the tax is owed. These are reasons to look at spreading gains out instead of incurring them all in one year. Keep in mind that depending on the time of year, you can spread income over two tax years but only stagger the sales over a couple of weeks if, for example, it is late December.
The reality for most investors is that not every security they purchase and hold is going to be a “winner”. Many folks own securities that for one reason or another didn’t perform positively and have a fair market value lower than the original purchase price and subsequent cost basis adjustments. This is known as having an unrealized capital loss. A strategy often employed to reduce capital gains is to “harvest tax losses” to offset capital gains. The key is to do this when your tax needs align with your overall outlook on the security you are selling. Keep in mind that when you sell a security in order to harvest a tax loss, you need to ensure that you have not traded in that security (or a substantially similar security) within the 30 days prior to the sale and 30 days after the sale (in all, a 61 day period). If you were to trade within this 61 day window, you would create a “wash sale, ” and your capital loss on the transaction would be disallowed. Avoiding “wash sale” transactions can be complex, and it is for that reason that we at Atlas recommend that our clients consult with us prior to executing a strategy for harvesting tax losses.
Keep in mind, not all assets are created equal as it relates to capital gains. Sales of personal residences or residential rental property have very different results in terms of tax projections or even what is considered taxable income. Working with an advisor who can run multiple scenarios and present you with options to better assess the timing and magnitude of capital gains, is important. Remember, while we know it isn’t fun to pay income taxes on capital gain income…it means your investments are appreciating and that is a great thing!
Looking for more resources on tax planning? You may visit our website and watch my Year-End 2019 Tax Planning webinar.
End Notes
1 https://www.investopedia.com/terms/c/capitalgain.asp
2 https://taxfoundation.org/2019-tax-brackets/
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