The last decade has seen extraordinary returns in the stock and bond markets. As a result of these returns, many of the families we work with have accumulated substantial unrealized capital gains. When these appreciated positions are sold inside of a taxable investment account (think non-retirement account), then capital gains are realized and a tax may be due. Here are some practical planning tips for managing the tax due on capital gains:
- Wait one year if possible before selling.
Short-term capital gains are gains incurred when an asset is sold less than a year after you purchased it, and are taxed as ordinary income. Investors generally prefer waiting 366 days before selling a security, as gains on assets held more than a year are considered long-term capital gains and are taxed at lower rates (15% and 20% depending on your income tax bracket).
- State income taxes will apply. If you live in a state that assesses an income tax, then you will probably pay ordinary state income tax rates on the gains, no matter how long you own the asset. The difference between short and long-term capital gains tax rates applies to the federal tax code only.
- Consider gifting the asset to a philanthropic organization. One common strategy for managing capital gains is to gift some or all of the appreciated securities to a registered charitable organization. The tax benefits of this strategy are twofold: first, the taxpayer receives a charitable deduction in the year of the gift, which can be used to offset income tax. Second, the taxpayer avoids capital gains altogether by gifting the security and rather than selling and gifting the net sale proceeds. Registered charities do not pay income or capital gains tax, so gifting appreciated securities directly to the charity essentially writes Uncle Sam out of the transaction.
- Gifting to trusts works too. Many taxpayers would love to give assets to a philanthropic organization, but would also like to draw an income stream from the gifted asset for a set period of time. Charitable Remainder Trusts are a great place to send highly appreciated securities if you’d like to receive an income stream from your gift. We have seen clients fund this sort of trust with appreciated stock which, in turn, has created an income to last their families well over a decade.
- You can give the assets to other people. When gifting assets to an individual (or to a trust for an individual’s benefit), it is important to remember that the recipient of the gift will also receive your cost basis. If you gift that highly appreciated asset to a family member and he or she then sells the asset, tax will be due based off your cost basis. This can be handy if your children make far less income than you do; however, there are all sorts of tax issues that come up when gifting inside of a family, so it is best to consult with a CPA before going too far down this path.
- Sell the asset and move along, capturing offsetting losses where possible. It is important to remember that long-term capital gains are taxed at a lower rate than all other sorts of earnings/income/appreciation. Keep that in mind as you consider realizing gains. (One of my mentors used to call this tax break the reward you receive for buying low and selling high.) It is important not to let the tax consequences color your decision on whether or not to sell the asset. If you elect to recognize capital gains, the earlier in the calendar year that you can sell the asset, the better, as this will give you the remainder of the year to recognize offsetting losses in your portfolio.
Please contact our planning team if you would like to discuss these strategies or any other financial planning items.