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Capital Gains Tax

Simply put, capital gains tax is the tax owed to federal, and possibly state, revenue departments from the gain on the sale of assets, such as stocks, real estate or other capital assets.  From there, the concept gets more complex.  In this post we’ll review some of the basics you should understand to be as tax-efficient in your planning for the sale of your assets.  The learning objectives for this post are:

1.    To understand the difference between long-term capital gains and short-term capital gains and which are more favorable from the investor’s perspective

2.    Learn how cost basis is used in the calculation of capital gains tax

3.    Recognize how asset placement can help minimize capital gains taxes

Purchasing investment assets does not usually involve the payment of any tax, with the exception of certain taxes that may be due on some real estate transactions.  Capital gains are taxed at the time an asset is sold, referred to as realized, and are generally due with your personal tax return filed in the first part of the following year.  Capital gains result if the price of the sale of an asset is higher than your cost basis from the purchase price of the asset, adjusted for other potential factors like depreciation, improvements, or in the case of stocks and mutual funds the reinvestment of dividend income.

A transaction may result in a capital loss if the price of the sale is lower than your cost basis of the investment.  Capital losses may be used to offset realized capital gains in the same year.  If your losses exceed gains by more than $3,000 in any one year, the excess loss is carried forward to subsequent tax years until it is used up against future capital gains.

Before going further, we should also identify that capital gains taxes only apply to assets held outside of qualified accounts or plans.  Examples of qualified plans are individual retirement accounts (IRAs), 401(k)s, pension plans, health savings accounts (HSAs) and other similar retirement planning vehicles.  There is no taxation of any capital gains or income in these plans.  Taxation for most results when plan assets are withdrawn in retirement when the amount taken out is taxed as ordinary income.  The exception is withdrawals from Roth IRAs and health savings accounts which are not taxed at all if the rules regarding withdrawals are followed.

The IRS rules regarding short-term and long-term capital gains have changed over the last several decades and will likely change again.  For our purposes here, we will use the current 2021 tax rules.  The current administration has outlined some potential changes for the tax code, which may change some of the following information, especially for higher income Americans.

Currently the dividing line between short-term and long-term gains is 12 months.  Long-term gains are taxed at rates from zero to 20% depending on where your annual income falls. High wage earners may pay an additional 3.8% Net Investment Income Tax, which is used to support the Medicare system.  Short-term capital gains are taxed as ordinary income, which for most will be a higher tax rate.  It pays, when possible, to hold assets for more than one year to obtain a lower tax rate.  Please note that most states also assess a capital gains tax on top of the federal tax rates quoted here and those rates vary widely.  The states that do not assess a state income tax, like Florida, do not charge a capital gains tax either.

Holding certain assets, like common stocks, for a long time may provide a double benefit.  First, if you don’t sell you don’t pay capital gains tax.  Next, dividend income from common stocks and certain real estate related investments are taxed at preferential rates compared to normal income tax rates.  It is always a great idea to check with your financial advisor or tax preparer to learn the tax favored treatment of different asset types and how that may benefit you.

Asset location may also be an important decision for reducing capital gains taxes, and taxes in general.  For example, if you are using a buy and hold strategy for the stock portion of your portfolio, placing those stocks in your non-qualified (taxable) brokerage account is probably a good idea for the favored tax rates mentioned above.  Using your qualified accounts to hold other assets that do not receive preferential tax treatment of current income will keep your tax bill lower.  If you are engaging in a strategy that results in more frequent asset sales with holding periods shorter than one year, your IRA or other qualified account is the best place to implement that technique.  Of course, everyone’s individual tax situation is different and working with your CPA or financial advisor will be helpful in determining the best location for different asset types.

Investment real estate offers some additional options for postponing the payment of capital gains tax on the sale of property.  Section 1031 of the IRA code details how this can be accomplished.  Again, your financial advisor or tax preparer can help with these situations.

If you have question about minimizing capital gains taxes, call us today at 941-778-1900 or visit www.integracapitaladvisors.com to schedule a time to talk with us about your situation.

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