A capital gain is an increase in the value of a specific asset, classified as a capital benefit when sold. Essentially, this term means nothing more than offloading something for a higher price than the sum you paid for it. In the financial sector, assets that get the capital label attached include bonds, stocks, homes, investment properties, vehicles, artworks, and even collectibles, virtual and physical. These items, per some experts, when categorized as capital ones, carry the caveat that their sale during regular business operation is unnecessary, and they usually have a lifespan longer than a year. Thus, they get utilized to generate revenues throughout one year or more.
Naturally, the government seeks to lay a tax on the levy on the profit someone makes when selling off an investment. These are due only after an investment gets sold. And according to America’s federal tax policy, the capital gains tax applies to only profits from sales of assets that a person or entity has held onto for over twelve months. These get called long-term capital gains, and they can get taxed using different rates (0%,15%, or 20%) depending on the yearly bracket a taxpayer finds himself in during a calendar year.
To circumvent paying capital gains taxes, many people and day traders seek to take advantage of the speed that online trading and stock performance tracker software allow them to resell assets held for less than a year. However, many of these persons don’t understand that by doing so, they get taxed at a higher rate than if they held onto them long-term. Below, a guide follows on what steps everyone can take to reduce the capital gains taxes they must pay by mid-April each year.
1. Employ an Advisor
Knowing methods that help curtail capital gains taxes is super beneficial for those in higher tax brackets. In-depth familiarity with such practices can ensure that an investor abides by all IRS rules and avoids unnecessary legal hassles in the future. Without question, for individuals unwilling to navigate these waters solo, the best course of action is to hire an experienced advisor. Or at least employ an automated one that offers tax optimization. Personal Capital’s Best Portfolio Management is a terrific choice for those with deep pockets, as it has excellent tax-minimization strategies. And Quicken Premier is an apt choice for those willing to pay $77.99 a year for a similar-quality service.
2. Offset Losses Against Gains
An investor may be able to offset some gains with applicable losses if they hold several different assets. For example, if an investor has an investment that has notched a drop of $5,000 and another that has recorded a jump of $8,000, selling them both will help reduce his gains. That person will only get subjected to the gain tax difference. Tax-loss harvesting is another approach for this tax avoidance genre (if we can call it so). It involves carrying over the losses from one year into the following one as a tool that should aid in offsetting future gains. Nevertheless, this only works if the losses in a specific year exceed the overall profits. In short, investors harvest a loss when an asset they hold loses in value, then use that money to purchase a new one, keeping their portfolio relatively diversified and safe.
3. Consider Securities-Based Lending
For the uninformed, this is borrowing funds while utilizing securities held as collateral in after-tax investment accounts. If a person comes to the realization that paying their capital gains tax may be too high, and they have no recourse on how to reduce or offset this obligation, then they can choose not to take the gain at all. Securities-based lending is something that traditionally gets made available by larger banks, advisory firms, or brokerages. Regarding the latter, many allow their investors to utilize their securities as collateral, backing a line of credit. That can come in handy when someone needs funds but does not wish to generate gains at an unfavorable period or liquidate their investments.
4. Monitor Mutual Fund Distribution
Know that mutual fund investors can get raked through the coal for capital gains annually, as these funds pull in money and redistribute it through the year. Of course, the success rate will vary year-to-year and fund-to-fund. As tax deadlines approach, an investor can look into their mutual fund’s estimates for capital gains distributions. If they have reached decently sized amounts, it may be beneficial for this investor to swap into another fund as a mechanism to bypass that capital gain distribution.
5. Take Advantage of Tax-Deferred Retirement Plans
A new survey from Bankrate shows that 55% of US workers believe they are behind on their retirement savings, and going by a Northwestern Mutual study, Americans think they need savings of $1.25 million to ensure their golden years are comfortable. While many are far from reaching this goal, most people’s retirement accounts are bulky, consisting of their savings and future assets. Hence, it is wise to cleverly optimize these via tax-deferred plans as a neat technique to avoid added capital gains fees. When someone contributes to a traditional IRA or a 401(K), they receive a tax deduction on their contributions in the current tax year, meaning they can save these funds on their income taxes now, letting them store more for the future.
6. The 1031 Exchange
Primarily only those in the real estate sphere are wise to the 1031 exchange, an investing tool in this sector that allows individuals to replace investment properties and defer capital gains/losses/capital gains tax they would otherwise pay at sale time. The 1031 exchange is an extremely popular instrument for those looking to upgrade properties without incurring any tax costs during this process. Note that anyone who follows through with this procedure must inform the IRS about their transactions through Form 882 on their return. They also must meet specific requirements to relinquish and replace properties in a 1031 exchange that are outside the scope of this article.
7. Flip Houses
Flipping a house is buying a structure in need of drastic repairs, remodeling it, and selling it for a profit. It gets presented as something easy, adding cosmetic touch-ups to a structure for a sale that results in a decent chunk of change, but it is not always so. In the first quarter of 2022, 10% of houses sold in the US underwent remodeling first, and many industry insiders claim that the formula to success in this field falls on the 70% rule. That is a formula that relies on the simple calculation: after-repair value x .70 − estimated repairs = maximum purchase price. To skillfully evade taxes, some flippers make their under-market investment houses their chief residences while working on them in a paperwork scheme. When they manage to sell them, they do not pay any gains tax thanks to the primary residence exclusion.
8. Exchange-Traded Funds
Exchange-traded products have gained steam recently because one of their biggest secrets has gone public – they are a tax loophole. ETFs or exchange-traded funds experience a much lower tax hit than what single investors in mutual funds face. They allow investors to circumvent a rule concerning taxes that is present in mutual fund transfers connected to declaring capital gains. Everyone choosing to use a mutual fund must know that when the fund sells something off, its shareholders get held accountable for the accrued gains. On the other hand, EFTs get structured so that these sales do not activate a taxable event. Thus, it may be worth putting some investments towards them, as they generally get considered low-risk.
9. Use Health Savings Accounts
HSAs receive a tax deduction for contributions placed in them. Health Savings accounts are savings ones that permit people to store funds on a pre-tax basis for future medical expenses. Investing in them does not produce any taxes as long as the investor uses withdrawals for only qualified health expenses. Also, contributions to HSAs roll over yearly, and sums can grow for a more significant medical need or as an investment after retirement.
10. Buy and Hold
Loads of people opt to purchase quality index funds that do not need to get sold. Yes, these will get locked and not be available for use for more substantial economic growth, but some investors are fine with that as they factor them into future plans.
11. Donate to Charity
Most financially illiterate folk are unaware that they can give stocks to charities. When they do that, they get the same tax deduction as giving the organization money. And, when/if the charity chooses to unload the received stocks, these sums do not get subjected to a capital gains tax. Virtually all nonprofits these days accept stocks as donations, which has resulted in them receiving loads, which they usually instantly liquidate. The primary reason parties choose to give them financial assets is to reduce future capital gains, potentially. But many do so to give their portfolio a health check when rebalancing it.
12. Gift Your Partner
If you have lived together with your spouse/civil partner for at least a part of the tax year, you can give them an asset as a gift. In multiple scenarios, individuals can escape paying capital gains tax in such transfers, as gifts customarily do not get considered income by the IRS. But if someone chooses to sell a gift at a fair market price. Then a capital gain or loss must get reported. You can gift stocks, and since you are giving it away for free, instead of selling it directly, you won’t owe capital gains tax,
13. Relocate to a Lower Tax Bracket State
Why not? The Golden State has a 37.1% rate on capital gains, the highest in the US and the second most massive worldwide. So, living in California can be costly for most entrepreneurs compared to residing in Tennessee, Florida, South Dakota, Washington, Texas, Wyoming, and Alaska, which add nothing extra to the federal rate of 23.8%. Therefore, if someone is paying dramatic tax amounts for the capital gains acquired in their bank accounts, maybe relocating should be in the cards.
14. Put Money Toward Distressed Areas
On account of a tax benefit introduced in 2017 through the Tax Cuts and Jobs Act, investors can lower their capital gains fees to government authorities if they choose to reinvest their gains into a QOF, which stands for a qualified opportunity fund. That is an investment vehicle organized as a partnership or corporation to funnel money to distressed communities throughout America. The federal government saw this rule as a break meant to enhance economic growth in struggling regions and create new jobs for those living there.
15. Hold on to What You Have For Life
That is also an option, as proven by the fact that many people die while holding very appreciated investments. If one selects this path, holding on to what they have until death, their heirs should not pay any capital gains tax. Many US financial analysts openly point out that the current law blatantly encourages the wealthy to hold on to what they hold until they perish because when they disappear, so does the due tax. That occurs because the law does not treat a bequest as a sale, and heirs do not pay taxes on the boosted value of a property during a decedent’s lifespan. That means that wealth inequality inadvertently or deliberately, depending on the interpretation, gets perpetuated through generations.
To Wrap Up
In most advisors’ opinion, the best way to avoid capital gains taxes on investments is to place them in a tax-advantaged account, like an IRA or a 401(K). The earnings that lay in these accounts do not get taxed until the holder takes distributions in retirement. The other tips presented above are also viable alternatives. Yet, some require hefty paperwork, and others may not be around for very long, as the IRS and government, in general, are continuously looking for ways to plug loopholes and find methods to fill their coffers.