By Greg Farrall, PPC®, CWS®, CPFA®
When Snoopy wrote a letter to the IRS saying, “Dear IRS, I am writing to you to cancel my subscription,” most of us could definitely relate. And if you have an investment or asset you are going to be selling for a profit, the IRS will surely come calling. But capital gains taxes don’t have to be such a burden if you employ a few strategies to help reduce your capital gains.
1. Wait a Little Longer to Sell
Timing the sale of your investments is critical to lowering your capital gains taxes. Selling your shares after holding for less than a year will result in a short-term capital gains tax. This means that all the gains you made from the sale of the stock will be taxed at your ordinary income rate, which can be 32%-37% for high-earners. Holding on to an asset for more than one year will be taxed at the long-term capital gains tax rate, which can be 0%, 15%, or 20%.
Holding periods are also critical when it comes to the sale of real estate. If you sell your primary home and you lived in the home for at least two years of the five-year period before the sale, the IRS allows you to exclude the first $250,000 of capital gains (or $500,000 for a married couple filing jointly). While the capital gains exclusions do not apply to investment properties, you may be able to utilize like-kind exchanges to defer capital gains tax by reinvesting in other real estate.
2. Utilize Tax-Loss Harvesting (TLH)
Losing money on your investments is usually a bad thing, but utilizing a tax-loss harvesting strategy means you can claim capital losses to offset your capital gains. If you show a net capital loss, you can use the loss to reduce your ordinary income by up to $3,000 (or $1,500 if you are married and filing separately). Losses above the IRS limit can be carried over to future years. Sometimes it is advantageous to sell depreciated assets for this reason. A tax-loss harvesting strategy can help minimize your tax liability and keep more money in your pocket. However, trying to reduce taxes shouldn’t come at the expense of maintaining a thoughtful asset allocation in your portfolio.
3. Asset Location
Some investments will be more tax-efficient than others. For example, a municipal bond is considered the most tax-efficient security because income from municipal bonds are federally tax-exempt and may be state tax-exempt. Investments like high-yield bonds are considered less tax-efficient because payments are not tax-exempt, meaning they are taxed as ordinary income.
Like assets, there are investment accounts that are more tax-friendly. Tax-advantaged accounts allow you to defer paying taxes on the gains or earnings to a later date. For example, a traditional IRA or a 401(k) will allow you to contribute using pre-tax income and withdrawals are taxed when you retire, when your income is typically lower.
Pairing tax-advantaged accounts like a 401(k) with tax-inefficient assets like a high-yield bond and pairing taxable accounts (individual, joint, trust, etc.) with more tax-efficient assets will create a more optimal mix to minimize tax liability. Placing investments that have higher tax rates with accounts that delay taxes will help reduce the amount you owe. Since you are not expected to pay federal taxes on something like income from a municipal bond, there is no use placing it in a tax-advantaged account because there are no taxes to delay.
Of course, this is a bit of an oversimplification as there are many nuances that can make certain investment vehicles more tax-efficient than others. For example, although REITs are at the bottom of the chart, there are still plenty of advantages to investing in them. Dividends from REITs are sheltered from corporate tax, and some dividends are considered a return of capital that isn’t taxed at all. This is why it is imperative to work with an experienced professional who can use the nuances of each financial instrument to your advantage.
4. Understand Cost Basis & Share Lots
When you buy any amount of stock, the stock is assigned a lot number regardless of the number of shares. If you have made multiple purchases of the same stock, each purchase is assigned to a different lot number with a different cost basis (determined by the price at the time of each purchase). Consequently, each lot will have appreciated or depreciated in different amounts. Some brokerage accounts use first in, first out (FIFO) by default. If you utilize FIFO, your oldest lots will be sold first. Sometimes FIFO makes sense, but not always. Sometimes it is ideal to sell lots with the highest cost basis, which is commonly done as part of a tax-loss harvesting strategy.
Passing on assets as an inheritance can also increase your cost basis. Assets passed on to the next generation at the time of death allow your heirs to pay tax only on capital gains that occur after they inherit your property, through a one-time “step up in basis.” For example, when one spouse dies, assets passed on to the surviving spouse will have a cost basis of the price of the asset on the day in which they passed. This eliminates the deceased spouse’s portion of capital gains.
We’re Here to Help
Minimizing capital gains taxes is only one component of a sound financial plan. Through our investment management services at Farrall Wealth, our goal is to minimize fees, reduce taxes, and seek to protect your investments while positioning them for growth. To learn more, call our office at 219-246-2516, email [email protected], or schedule a complimentary consultation online. Be sure to visit our website to learn more and connect with us on LinkedIn, Facebook, Twitter, and YouTube.
Greg Farrall is CEO and owner of Farrall Wealth, an independent, boutique wealth management firm that is dedicated to helping women and business owners create customized financial plans that allow them to grow, protect, preserve, and distribute their wealth. Greg is known for being a problem-solver who walks his clients through whatever life throws at them. He prioritizes building long-term relationships and is passionate about going the extra mile for his clients so they can pursue their goals and live the lives they want. Greg has a bachelor’s degree in international business from the University of Wollongong in Australia and a bachelor’s degree in finance and marketing from Indiana University Bloomington. He is a Professional Plan Consultant® (PPC®) and a Certified Wealth Strategist® (CWS®) professional. And he recently received his Certified Plan Fiduciary Advisor (CPFA®) designation. You can listen to him on his financial literacy and business topic podcast, Money Matters With Greg, on iTunes, Google, and Spotify. He’s also on YouTube, Twitter, and Facebook at @FarrallWealth.
Greg is a pillar of his community and served as the 2013-14 co-chair for the United Way campaign, through which he helped raise $1.8 million for 38 nonprofit organizations across Porter County, Indiana. He also served as president of the Valparaiso Rotary Club. Currently, he is on the advisory board for the Kelley School of Business and Dean of Students’ board at Indiana University. He also holds a position on the Culver Academies parents’ board.
When he is not working, you can find Greg spending time with his family or investing in one of his many passions, which include cooking, Spartan races, fly fishing, and meditation. To learn more about Greg, connect with him on LinkedIn.
Securities and advisory services offered through LPL Financial, a registered investment advisor. Member FINRA/SIPC.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest you discuss your specific tax issues with a qualified tax advisor.
No strategy assures success or protects against loss.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
Investing in Real Estate Investment Trusts (REITS) involves special risks such as potential liquidity and may not be suitable fr all investors. Three is no assurance that the investment objectives of this program will be attained.