A capital gain is the net profit realized by a person that has sold a capital asset for an amount greater than what they have invested into that asset. Without getting too technical, a capital asset is generally any asset that is held for investment and does not consist of property that is intended to be sold in the normal course of the taxpayer’s trade or business.
The Federal tax rate on a capital gain is often lower than the tax rate that applies to ordinary income (for instance, compensation earned as an employee). For instance, a taxpayer who is in the top Federal tax bracket of 37% for the 2023 tax year (taxable income exceeding $578,125, or $693,750 for married taxpayers filing jointly) would be subject to an effective tax rate of 23.8% on their capital gains. Additionally, a taxpayer whose taxable income is less than $44,725 for tax year 2023 (or $89,450 for married taxpayers filing jointly) will have their capital gains taxed at 0% for Federal tax purposes. These same tax rates also apply to qualified dividends, which are distributions of a corporation’s earnings and profits to the shareholders whose holding period in the stock meet certain requirements.
The unveiling of President Biden’s budget proposal on March 9th, 2023 has, among other things, called for capital gains and qualified dividends to be taxed as ordinary income for individuals whose income exceeds $1 million ($500,000 for married taxpayers who file separate returns), effectively reigniting the debate of how capital gains should be taxed. Those who support a lower tax rate on capital gains argue that it is not fair to treat capital gains and ordinary income the same way for tax purposes, since they deal with two separate and distinct activities (i.e., holding investments versus actively participating in a trade or business). On the other hand, some folks believe a lower tax rate on capital gains and qualified dividends unfairly benefits wealthier taxpayers, and that taxing this investment income at ordinary income tax rates would help ensure that the wealthiest taxpayers pay their “fair share” of taxes.
Capital Gains Tax Tips
With some careful planning, there are a few ways to defer, minimize, and possibly exclude capital gains from your income tax return:
1.) Harvesting capital gains and losses
This is the process of reviewing your investment portfolio throughout the year, especially near the beginning and end of each year, and locking in your gains or losses in one or more positions. It’s all about the timing of when each of these transactions take place. For instance, selling a stock for a capital gain in January 2023 means you do not have to pay the tax on such gain until April 15, 2024, the due date for filing your 2023 income tax return. On the other hand, realizing a capital loss in December 2023 can provide you with the tax benefit of deducting the capital loss much sooner than if the same loss was taken in January 2023.
This tax planning technique should be done with the guidance of a qualified professional – and in many cases, that professional is not your tax accountant, nor should it be. If you are triggering capital gains and losses merely for tax-motivated reasons, doing so may not necessarily be in line with your overall investment objectives.
2.) Watch out for the wash sale rules
If you sell stocks or other investments at a loss, and you acquire a new position in that same security within 30 days of realizing the loss on sale of your prior position in that stock, the capital loss is disallowed. The purpose of the wash sale rules is to discourage taxpayers from artificially generating capital losses for an investment they continue to hold, except for the short time they sold the investment at a loss and then re-established their position in the same investment a short time later.
3.) Donate appreciated property to a qualified charitable organization
When executed properly, the donation of property that has appreciated in value (for instance, the stock of a publicly traded corporation) gives the donor a charitable contribution deduction equal to the fair market value of the security on the date of contribution, which can often be significant. This is often a more effective strategy than selling the stock and donating the cash proceeds to a charity, as some states impose a limitation on itemized deductions (including charitable contributions) for higher-income taxpayers.
4.) You can also hold onto your appreciated property until you die
While choosing not to sell a capital asset is probably the easiest way to avoid having a capital gain, it also provides a potential future tax savings to the beneficiaries of your estate. Under the current tax code, assets that are transferred to a taxpayer’s heirs upon their death receive a “step-up” in basis, which effectively increases the basis of the asset to its fair market value as of the decedent’s date of death. When the heirs sell that property in the future, their increased basis will help them avoid paying capital gains tax they would otherwise owe if the same property were transferred during the transferor’s lifetime.
One important note: this area of the tax code would be modified significantly if the tax provisions from the Biden administration’s budget proposal dated March 9th, 2023 are enacted into law as currently proposed.
5.) Are you selling your home?
The tax code allows taxpayers who have owned and lived in their home as their primary residence for any two out of the prior five tax years to exclude up to $250,000 of the capital gain that is realized upon selling your home. Married taxpayers that file a joint income tax return are able to exclude up to $500,000 of such gains. There are some exceptions that apply to these rules, so be sure to discuss your particular tax situation with a qualified tax professional.
6.) Reinvestment of capital gains into a qualified opportunity fund (QOF)
This strategy is available if you have a capital gain, and within 180 days of the realization event you make an investment into a qualified opportunity fund (QOF), and on your income tax return for that year you make an election to defer some or all of your eligible capital gains on the transaction. A QOF is an entity whose purpose is to invest in businesses and activities that are established primarily in economically distressed areas. In addition, holding an eligible QOF investment for at least 10 years can result in the elimination of all gains that would otherwise be recognized upon a disposition of either the QOF ownership interest, or a sale of the underlying property owned by the QOF.
The deferred capital gain must be recognized as income on the earlier of the date the QOF investment is disposed or December 31, 2026. Currently, it is not known what tax rate will apply to capital gains in 2026, so there is some risk that the tax on a deferred capital gain could be higher in that year versus the year in which the gain was originally realized. There are many complex rules and requirements in this area, which fall outside the scope of this article. Anyone who is considering a QOF investment should consult with a professional that is an expert in this area.
If you need further guidance or have any questions on this topic, we are here to help. Please do not hesitate to reach out to our trusted experts to discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.