Capital gains taxes have been in the news and top of mind for higher net worth investors. For those who make over $1 million in income, proposed tax increases could double the capital gains tax rate to help fund initiatives aimed at boosting the U.S. economy.
Whether the proposed tax increases move forward or other changes come up later, being proactive about managing your investments can help reduce your capital gains tax bill, retaining more assets for you to invest and grow.
Note: Our focus in this article is on capital gains strategies for securities investing. If you're looking for a strategy to minimize capital gains taxes on real estate investments, read our story on 1031 exchanges.
Match asset location and investment choice
There are various types of investment accounts, some of which are tax-advantaged. For example, 401(k)s, IRAs, 529s, HSAs and irrevocable trusts provide different tax benefits. Being thoughtful and intentional with which accounts you save into and the investment selections within each type of account can help trim your tax burden.
A good rule of thumb is to use tax-advantaged accounts for more actively traded positions or less tax-efficient investments and to direct your buy-and-hold investments or more tax-efficient investments into taxable brokerage accounts.
Take a longer-term view
If you need to liquidate investments within your taxable brokerage account, examine the amount of time you’ve held onto each investment position. When the position you wish to sell has made a gain, you’ll get hit with capital gains taxes. If possible, try to sell positions that are at least a year old, so that you can pay the more favorable long-term capital gains tax rates instead of short-term capital gains tax rates.
Harvest tax losses
If you’ve accumulated capital gains for the year, check your taxable account to see if other investment positions might have produced capital losses. In that case, realizing those losses, assuming you’re willing to part with the positions, could help offset outstanding capital gains. Tax-loss harvesting allows investors to offset up to $3,000 of ordinary income per year, but beware of wash sales and cost basis calculations to stay within the rules (more about tax-loss harvesting and related rules here).
After offsetting current-year losses, additional realized capital losses can be carried over to future years.
Oftentimes, savvy investors with the luxury of flexibility will await a year with more capital losses before liquidating investment positions with more sizable capital gains.
Harvest tax gains
In addition to harvesting capital losses, investors can harvest their capital gains. This means that investors purposefully await years in which their taxable income is less to realize capital gains on their investments.
Perhaps you changed jobs or took some time off and happened to fall into a lower tax bracket than normal. Or you’ve retired and have a lower income for a couple of years before required minimum distributions kick in. There are many reasons your taxable income might fluctuate from one year to the next.
Even without changes in taxable income, taking gains could make sense. Some investors wanting to sell a winning stock may unwind their position over the course of several years, stretching out their tax consequences. For instance, liquidating one-third of a position at the end of 2020, one-third during 2021, and one-third in the beginning of 2022 would take just over a year to accomplish but allow an investor to distribute the capital gains taxes across three tax years.
There are times in which capital gains tax increases might be on the horizon. Selling your winning investment positions could make sense if you’d like to reduce capital gains taxes you may owe down the road. Even if you repurchase the same security, resetting the cost basis can avoid greater capital gains taxes later.
As with all tax strategies, be careful of IRS rules. Wash sale rules must be followed, and selling assets could trigger a different tax, the 3.8% charge on net investment income, depending upon your financial situation. Be sure to consult with your tax advisor before taking action to ensure the strategy will work for you.
Monitor mutual fund distributions
If you’re a mutual fund investor, you could be subject to capital gains taxes at the end of each year. Mutual funds acquire capital gains and income distributions throughout the year as they trade in and out of investment positions. Some years, a mutual fund may have sufficient losses to take (or losses carried over from prior years) to cover realized gains. In other years, capital gains will need to be passed through to shareholders; this can be more common when markets continually hit new highs over a prolonged period.
Toward the end of the year, investors can check a mutual fund company’s estimates for capital gains distributions. If the distributions are significant for a fund you hold, it may be worthwhile to swap into another fund to try to sidestep that capital gain distribution.
Give away appreciated assets
If you don’t need to liquidate all of your assets to cover daily living expenses, giving highly appreciated securities to charity or to heirs can lessen your capital gains tax liability.
When donating an appreciated security directly to charity instead of giving cash, you can bypass paying taxes on the capital gain, providing an additional perk on top of the tax deduction for charitable contributions.
If you leave your appreciated securities to heirs, they will receive a step up in cost basis upon your death. This means that the price of the security on the date of your death will become the new cost basis for your heirs.
Invest in distressed communities
The 2017 Tax Cuts and Jobs Act created a new tax benefit allowing investors to defer and minimize capital gains taxes when reinvesting their capital gains into a Qualified Opportunity Fund. QOFs invest in distressed communities throughout the U.S., and this tax break is meant to help create jobs and propel economic growth in these areas.
Some rules do apply. The taxpayer must reinvest capital gains into a QOF within 180 days. The longer the QOF investment is held, the more tax benefits apply:
Holding for at least five years excludes 10% of the original deferred gain.
Holding for at least seven years excludes 15% of the original deferred gain.
Holding for at least 10 years can eliminate most, if not all, of the deferred gains.
Consider securities-based lending
If you find that realizing a capital gain will be too costly, without means to significantly offset or reduce it, another option to consider is just not taking the gain at all.
Many brokerage firms allow investors with a taxable brokerage account to use their securities as collateral backing a line of credit. Having a line of credit means you can access cash at any time. This can be beneficial to investors who need a source of funds but would prefer not to liquidate their investments and generate gains (or losses) at an inopportune time.
There are caveats: Should the investments drop in value, the brokerage firm will usually demand the investor pony up additional assets to replenish the account. Also, securities-based lines of credit cannot be used to buy other securities or repay margin loans.