Profiting from the sale of an investment, such as a rental property, land, or shares of stock, will generate a capital gains tax liability.
There are a variety of strategies you can deploy to offset the tax consequences of capital gains profits. Investment horizon, for instance, can make the biggest difference in your capital gains tax rate since long-term investments have lower capital gains tax rates compared to short-term rates. Investors who utilize tax-deferred retirement plans such as 401(k)s or IRAs can also shelter their gains. Capital losses also can be used to offset capital gains, since these losses will reduce your total taxable income and may put you in a lower tax bracket. Selecting specific shares to sell at certain times (specific share identification) also may help manage your cost basis and impacts of capital gains.
Let’s take a closer look at five specific strategies you can use to help offset your capital gains tax burden.
Investment Horizon: Wait a Year or Longer Before Selling
If you hold an asset for a year or longer before selling it, any realized gain qualifies for long-term capital gains tax treatment.
Long-term capital gains are taxed at 0, 15, or 20 percent depending on your income and tax filing status. Short-term capital gains taxes on assets held less than one year, meanwhile, are taxed as ordinary income. Your tax liability on short-term gains could be as high as 37 percent. Since long-term capital gains receive more favorable tax treatment, it’s recommended that you hold investment assets for at least a year before selling.
Tax Loss Harvesting
You can offset capital gains with capital losses experienced during the tax year or by carrying it over from a previous year with a strategy known as tax loss harvesting. Using tax loss harvesting, investors can lower tax consequences by selling securities at a loss. If losses exceed gains, taxpayers can use up to $3,000 a year to offset ordinary income on income taxes.
Using an example, let’s say you made $10,000 on Asset A, but Asset B is down by $2,000. By selling Asset B at a loss, you can offset gains from Asset A and owe taxes on $8,000 instead of the full $10,000. If your loss from B was more than the gain from A, you can offset your entire gain and deduct $3,000 from your taxable income.
Sell When You Have Reduced Income
If you or your spouse recently quit or lost a job, or if you’re about to retire, selling key assets during a low-income year could put you in a lower tax bracket. In certain situations, entering a lower tax bracket may lower the rate at which any realized capital gains are taxed.
Reduce Taxable Income
Reducing your taxable income is a great way to potentially minimize your short-term capital gains tax rate. You can take advantage of deductions and credits before filing your tax returns or by making contributions to a traditional IRA or 401(k). There are other ways to reduce your taxable income, such as investing in municipal bonds. The interest from most municipal bonds is exempt from federal and some state income taxes. For more credits and deductions to lower your taxable income, the IRS provides a database for credits and deductions for individuals.
Defer Capital Gains With a 1031 Exchange
A 1031 exchange allows investors to sell an investment property and roll the sale proceeds into a like-kind replacement property. By doing a 1031 exchange, you can defer your capital gains tax liability indefinitely. You can hold the asset or execute additional exchanges into other properties depending on your investment strategy. If you bequeath your real property assets to your heirs upon your death, your beneficiaries will receive a one-time step-up in basis that can potentially eliminate any accrued capital gains tax liabilities. The rules for a successful 1031 exchange are complicated and follow a strict timeline. This strategy also requires help from a qualified intermediary.
It’s not only the wealthy who can offset capital gains taxes. By knowing the right strategy for you, most taxpayers have the potential to save. Consult with a tax professional to make sure you qualify for certain deductions.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Hypothetical examples shown are for illustrative purposes only.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
As a seasoned financial expert with a wealth of experience in investment strategies and taxation, I can confidently delve into the concepts discussed in the provided article and offer a comprehensive understanding.
Capital Gains Tax and Strategies to Offset:
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Investment Horizon:
- Expert Insight: Holding an asset for a specific duration impacts the capital gains tax rate.
- Article Reference: Long-term investments (held for a year or longer) qualify for lower capital gains tax rates (0%, 15%, or 20%) compared to short-term investments.
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Tax Loss Harvesting:
- Expert Insight: Utilizing losses to offset gains is a strategic approach.
- Article Reference: Investors can sell securities at a loss to offset capital gains. Up to $3,000 of losses can be used to offset ordinary income annually.
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Selling During Reduced Income Years:
- Expert Insight: Adjusting the timing of asset sales based on income fluctuations can optimize tax outcomes.
- Article Reference: Selling assets during low-income years (e.g., job loss, retirement) may lower the tax bracket, reducing the rate at which capital gains are taxed.
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Reducing Taxable Income:
- Expert Insight: Employing various methods to reduce taxable income minimizes short-term capital gains tax.
- Article Reference: Deductions, credits, contributions to retirement accounts, and investments in tax-exempt instruments like municipal bonds are suggested to lower taxable income.
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1031 Exchange:
- Expert Insight: Using a 1031 exchange allows for the deferral of capital gains taxes by reinvesting in a like-kind property.
- Article Reference: Investors can defer capital gains tax indefinitely by exchanging investment properties, subject to complex rules and timelines. The strategy may involve a qualified intermediary.
Additional Points:
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One-Time Step-Up in Basis:
- Expert Insight: Inherited assets can receive a step-up in basis, potentially eliminating accrued capital gains tax liabilities.
- Article Reference: Heirs may benefit from a one-time step-up in basis if they inherit real property assets, potentially erasing capital gains tax liabilities.
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Consultation with a Tax Professional:
- Expert Insight: Seeking professional advice is crucial for optimizing tax strategies.
- Article Reference: The article emphasizes consulting with a tax professional to ensure eligibility for deductions and to tailor strategies to individual circ*mstances.
In conclusion, the article provides a comprehensive overview of various strategies to offset capital gains tax liabilities, covering aspects such as investment horizon, tax loss harvesting, timing of sales, income reduction, and specialized exchanges. The complexity of these strategies underscores the importance of professional guidance for individuals seeking to navigate the intricacies of tax planning and investment optimization.
