You may lose quite a bit of the profit from your investment because of capital gain taxes, more so if you are not aware of any other smart tax strategies to use. Being informed about capital gains taxes and strategically planning your investment sales can often result in sidelining a good portion of your profits. In this article, we will discuss how capital gains tax applies and examine some strategies that can aid in reducing it.
Understanding Capital Gains Taxes
Taxes on any capital gain or profit you earn from selling an investment for a price greater than what you paid is taxed capital gains. A tax is charged on the amount of profit made on the sale, which is also called as capital gain. Capital gains are divided into two categories:
- Short-term Capital Gains: Any profit you make from selling an investment that you have had for one year or less is termed as short-term capital gains. If counted as such, this profit is taxed at your ordinary income tax rate which could, depending on your income, amount to a taxing as steep as 37%.
- Long-Term Capital Gains: If you dispose of an investment after more than one year, the profit is classified as long-term capital gains. These are usually taxed at lower rates— 0%, 15%, or 20%, depending on your income level.
Because long-term capital gains are taxed more favorably, many investors shift their focus to trying to maximize value on long-term holdings while minimizing short-term capital gains. However, even amid long-term investments, some methods can allow for greater tax efficiency.
Methods to Reduce Capital Gains Taxes Efficiently
1. Hold Investments for the Long Term
Keeping an investment for longer than a year is the most effective way to ensure lower capital gains taxes. Long-term capital gains taxes are significantly lower than those of short-term capital gains which is why it is most beneficial to stay clear of the “short-term” label. This advantage allows investors to take advantage of a lower tax rate.
Apart from this, equity investments tend to appreciate further over an extended period which translates to greater opportunities for use of compound growth. Therefore, holding onto these investments long-term as it aids in generating wealth while minimizing tax burdens.
2. Offset Gains with Losses (Tax-Loss Harvesting)
Tax-loss harvesting is an investment strategy that involves selling underperforming securities to balance the profits you’ve made on your other investments. This might help in minimizing your taxable capital gains. In simpler terms, it lets you “harvest” your losses to “offset” your gains, thereby reducing the total amount of taxable income by capital gains.
For instance, if your capital gains are $10,000 and capital losses are $4,000, the taxable capital gain will only be $6,000. Moreover, if your losses exceed your gains, you may use losses against other income, up to the limit of $3,000 for the year. Unused losses are saved for future gains.
Important Note: Watch out for the “wash sale rule”, which prevents the deduction of loss sales if a substantially identical security is repurchased within 30 days before or after the sale.
3. Tax Advantaged Accounts
Capital gains taxes have the greatest chance of being minimized professionally through tax favored investment accounts such as Individual Retirement Accounts (IRAs), 401(k) plans, and Health Savings Accounts (HSAs). The growth and realization of value of these accounts is tax deferred or even tax exempt which means you may not have pay capital gains taxes until the funds are removed.
- Traditional IRA or 401(k): You can postpone your taxes on capital gains and other income until you withdraw the funds upon reaching retirement age. Since your money is going to be taxed when you withdraw it, which at times is a lower bracket tax, your investments get a years of compounding at no tax efficiency.
- Roth IRA or Roth 401(k): These accounts let you withdraw in retirement without having to pay taxes on your capital gains, as long certain conditions are met. A major benefit of Roth IRAs is that they allow your investments to appreciate without being subjected to tax which is valuable in a longer duration horizon.
- Health Savings Account (HSA): An HSA-qualifying individual can make contributions that are deductible from taxes, expenses on qualified medical accounts can be withdrawn tax-free, and investment made grows tax-free. An HSA, similar to a Roth IRA, provides an opportunity for growth without taxes, substantially mitigating the burden of capital gains taxes.
4. Utilize the Capital Gains Tax Exemption on Your Home Address
When selling your primary home, a profit you make will incur tax only on a portion of capital gains if a certain profit threshold is met. The IRS lets you profit from the sale of your home while excluding up to $250,000 of capital gains ($500,000 for married couples filing jointly) provided you meet certain criteria.
To qualify for this exclusion, you must have:
- Resided in the house for a minimum of two years within the last five years before the sale.
- Not excluded proceeds from selling another house in the preceding two years.
This tactic can provide a lot of benefits, especially if a significant increase in home value is observed.
5. Gift Appreciated Assets to Family Members
Another useful approach for reducing capital gains taxes is to gift appreciated assets to family members who are in the lower tax brackets. When someone else is given assets to manage, they receive these assets at a certain cost and thus do not incur losses when selling them (also known as a “carryover basis”). In other words, the recipient has to pay capital gains taxes, but only on the gap between the selling price and the original purchase price (also referred to as the basis).
On the other hand, gifting appreciated assets can be advantageous if the recipient is below your tax bracket. In this situation, the recipient is likely to pay a lower tax rate on capital gains than you would have paid had you retained the asset. Also, note the rules associated with gift tax: For 2022, every individual is allowed to gift up to $16,000 per individual without incurring a gift tax.
6. Invest in Opportunity Zones
Through the Opportunity Zone program an investor can reduce or completely evade paying capital gains tax by investing in low income regions (Opportunity Zones). These zones are set-up through the Tax Cuts and Jobs Act of 2017. If one invests in a Qualified Opportunity Fund (QOF) and maintains it for at least a decade, the investor may exclude all profits made from the QOF from taxes.
This is a longer-term strategy, as thereas holding the investment for a decade, but it can assist in delaying and eliminating capital gains taxes on certain investments.
7. Be Strategic About Your Tax Bracket
Being aware of what your tax bracket is becomes important when figuring out capital gains. Let’s say, for instance, you’re just about at the top of a lower tax bracket. In this case, it is best to postpone selling some investments till the next year to avoid higher tax payments. In the same way, couple of months of lower income due to retirement, a sabbatical, or losing a business means it’s best to sell certain investments, as they can be sold at a more advantageous tax rate.
Conclusion
Relief from paying capital gains taxes involves an intricate combination of tax-planning strategies, investments, and a clear grasp of the law. Long-term holding of an asset, offsetting gains with losses, employing tax-sheltered accounts, utilization of special exclusions, and taking advantage of certain tax options enables one to lower their tax liability and maximize investment profits.
Seeking help from financial or tax experts help target optimal strategies for one’s unique financial circumstances. Proper planning allows reducing capital gains taxes significantly while increasing investment returns.