For those with taxable investments, planning for capital gains taxes and taking steps to mitigate your tax bill is an annual tradition. If you have a financial planner or CPA, it’s likely they’ve taken most of this responsibility off your hands or at least helped you address it. If you’re on your own, however, mitigating capital gains taxes can be daunting, if not confusing endeavor. Tax laws, exceptions, and the availability of different strategies all aid in complicating this pursuit. This article, however, is designed to help you better understand the basics of capital gains taxes, the various methods used for reducing or even avoiding them, and how you report and pay capital gains taxes to the IRS.
What is a Capital Gain?
A capital gain is a rise in the value of a capital asset. Capital assets “are significant pieces of property such as homes, cars, investment properties, stocks, bonds, and even collectibles or art.”
Short-Term vs Long-Term
The amount of time that passes between the purchase and the sale of a capital asset dictates whether it’s a short-term or long-term capital gain and how it’s taxed.
If a capital asset is purchased and then sold for a gain within 12 months, it’s considered short-term and is taxed at your ordinary income tax rate.
If the gain is realized beyond 12 months, it’s considered long-term and is taxed at the more favorable 0%, 15%, or 20% depending on your income (see Figure 1 below). Collectibles, however, are the one exception as they’re taxed at 28%.
Exclusion for Sale of Your Home
As per IRS Topic No. 701, “If you have a capital gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return with your spouse.” This is a tremendous benefit if you’re a homeowner with a sizeable gain on your home. The one caveat is that you do have to own and maintain your home as your primary residence for at least 2 of the 5 years immediately preceding its sale. You can’t just buy a house, turn around and sell it for a gain 13 months later and expect not to pay taxes. You have to actually live in it for at least 2 years.
Methods of Reduction
Tax-loss harvesting is the most direct way to reduce your capital gains taxes. It’s accomplished by selling certain investment assets at a loss to offset realized capital gains. You can also use tax-loss harvesting to reduce non-investment income (e.g. wages) by up to $3000 per year.
Since both long-term and short-term gains exist, there’s a specific order to how capital losses offset capital gains. First, long-term losses are applied to long-term gains, while short-term losses are applied to short-term gains.
You need to be strategic about how you tax-loss harvest so you don’t find yourself in trouble with the wash-sale rule. Where you sell a stock or security at a loss and then buy a “substantially identical” stock or security within 30 days. Doing so voids your ability to use that loss to offset any capital gains for tax purposes.
Reduce Taxable Income
The tax rate you pay for capital gains is based entirely on your adjusted gross income. As a result, commonly-used tax-saving strategies can also work well to reduce your capital gains taxes. Some examples of tax-saving strategies include making pre-tax contributions to a 401(k), IRA, and/or HSA, taking advantage of tax deductions and credits, and using municipal bonds for tax-free income from taxable investment accounts.
Gift Assets to Family Members
The IRS will allow you to gift up to $15,000 per person ($30,000 if married) without having to pay any gift tax. This means for those who have a substantial unrealized gain in a particular stock or fund, and they want reduce or avoid the capital gains tax, could gift a portion of appreciated stock or fund to a family member. That family member would then pay capital gains tax in their tax bracket, not yours. This is particularly beneficial if you’re rather wealthy and have a sizeable amount of taxable assets.
Donate to Charity
Unlike gifting assets to family members, there’s no limit on the amount you can donate to charity without incurring tax consequences. There’s also a greater number of tax benefits available for doing so. Charities are tax-exempt organizations, so they don’t pay taxes on realized capital gains as long as the proceeds are used for the charity’s main purpose. As the donor, you also get to deduct the fair market value of the appreciated asset on your tax return.
For example, if you bought 200 shares of XYZ stock at $200 per share and they appreciated to $500 per share, at which point you then donated it all to charity, you paid $40,000 for those shares, but you get to deduct a $100,000 charitable donation. When the charity sells it, neither of you pay capital gains tax on the gain. For high net-worth individuals and families, charitable deductions become an important piece of their overall tax mitigation strategy.
Wait a Year to Sell
The last method I’ll cover is the simplest one: avoid short-term capital gains. As long as you wait longer than a year to sell a capital asset, you’ll only be subject to long-term capital gains tax rates. Long-term capital gains tax rates will always be lower than your marginal tax rate so if you’re realizing gains on a taxable investment, long-term is typically the way to go.
However, it can be strategic to realize short-term capital gains in particular scenarios. For example, if you had a concentrated stock position that comprised a large portion of your net worth, or have stock options you want to diversify immediately after exercising. In these scenarios, you’ve deemed the long-term risk reduction more valuable or more suitable to accomplishing your financial goals than the taxes paid on the short-term gain.
Report and Pay
You’ll always report any capital gains you realized during the tax year on your annual tax return along with any other sources of income. The capital gain transactions themselves are reported on your Schedule D while any securities you sell get reported on Form 8949. As I mentioned earlier, you can deduct up to $3,000 in capital losses from your income, which is reported on Line 13 on your Form 1040. Capital gains taxes are then paid when you file your return.
Hopefully, this guide has helped you better understand the ins and out of capital gains and some methods you can use to reduce or avoid them. If you find you’re still needing help or have questions on your own capital gains tax situation, schedule a free consultation with us today to see how we can help.
Chad Rixse grew up in Anchorage, Alaska, but has lived in the Seattle area since 2007. He majored in Spanish at the University of Washington where he honed his fluency in the language and discovered his passion for travel and connecting with other cultures. He’s a self-professed golf addict who can never seem to get his fill despite still struggling to break 100.