Timing Your Investment Sales, Gifts and More

Last update on: Oct 27 2016

We’re heading into the end of the year. For many people, this is an opportunity to minimize your income taxes for the year, especially capital gains taxes. Actions you take, or don’t take, the rest of the year could have a substantial impact on your 2016 tax bill.

Before we dive into the details, keep in mind that the rules are in effect all year, and the strategies we’re going to discuss can be profitable for you at different times during the year. Next year, don’t wait until the end of the year to engage in tax planning. Keep these tax rules and strategies in mind all year. As markets fluctuate during the year, you likely will see opportunities to trim the IRS’s slice of your investment gains and income.

When you sell a capital asset from a taxable account, you’ll have a gain or loss, and it will be either short-term or long-term. When you held the asset for one year or less, the gain or loss is short-term. Hold the asset for more than one year, and the gain or loss is long term.

You know that a long-term gain faces a maximum tax rate of 20% (23.8% if your income is high enough to trigger the 3.8% net investment income surtax). At modest income levels, the maximum long-term rate is 10% or even 0%. Short-term gains are taxed as ordinary income.

When you have capital losses for the year, the losses first are deducted against any gains. When losses exceed gains, up to $3,000 of net losses can be deducted against other income. Any additional losses are carried forward to future years to be used in the same way until they are exhausted.

You report capital gains and losses on Schedule D of Form 1040. What many people don’t realize is that first you separately net the short-term and longterm transactions. On the top half of Schedule D, the short-term transactions are netted against each other to generate either a net short-term capital gain or loss. On the bottom half of Schedule D, the long-term transactions are netted to arrive at a long-term net gain or loss.

For example, suppose after the netting process you have a net short-term capital loss of $5,000 and a net long-term gain of $7,000. The result is a net longterm capital gain of $2,000 taxed at the maximum tax rate of 20% (or 23.8% for higher income taxpayers).

Let’s review the strategies that can be developed from these rules.

Taking losses. Most investors are averse to selling at a loss. They often plan to hold the investment at least until it returns to their purchase price. But taking a tax loss often is the better use of your capital. The loss reduces taxes on either your capital gains for the year or other income when losses exceed gains. A big loss can be carried forward to future years and reduce taxes on future gains and other income, sometimes for years.

In addition, once you sell an investment at a loss you can invest the sale proceeds in a more productive investment. Over the long-term, you’re likely to generate more wealth by taking a loss to reduce taxes today and free the capital to invest elsewhere instead of waiting for the losing investment to rebound.

You might not want to sell a losing investment in a year when you have a large amount of capital gains, because those gains already are tax advantaged. You might want to wait until the next year so the losses are most likely to offset short-term gains or ordinary income. But it is a close call. It is better to have the losses offset any taxes, even long-term capital gains taxes, than to let the losses sit in your account.

If you still like the investment, you can sell it, deduct the loss and reinvest the proceeds in the same asset after waiting more than 30 days. Or you can invest right away in another investment that isn’t “substantially similar.” This means you can sell a mutual fund and invest in a mutual fund with a similar investment style at a different fund company. Or you can sell a stock and buy either another stock in the same industry or an exchange-traded fund focused on that industry.

Let gains run. Short-term capital gains are taxed as ordinary income at your highest tax rate. Ideally, you want to avoid selling an investment in a taxable account until you’ve held it more than one year. You don’t want taxes to override what makes investment sense. So, when your investment strategy says an investment should be sold for a short-term gain, don’t hold it for months hoping it will mature to a long-term capital gain. When you do take short-term gains, look for losses you can take to offset them.

Know your tax bracket. The tax on your gains can fluctuate with your tax bracket. If your income varies from year to year, you might factor that into your decision of when to sell. Someone who normally has a very high income might avoid the 3.8% net investment income surtax by selling long-term capital gain assets in a year when other sources of income are lower. Other people might find that lower income one year reduces their long-term capital gains rate below 20%, to 10% or even 0%.

The bottom line is that you might have an opportunity to take gains at a lower tax cost by selling in a year when you retire, lose a job, work fewer hours, or business is down. When large tax deductions one year reduce your taxable income, that also could be a good time to take some extra capital gains.

In years when income isn’t down or deductions aren’t up, be careful about the amount of gains you take. The gains will increase your adjusted gross income, and a higher adjusted gross income can trigger the stealth taxes, such as income taxes on Social Security benefits, the Medicare premium surtax, reductions in itemized deductions and personal exemptions, and more. Many people took large gains in one year only to find that the higher gains triggered one or more of the stealth taxes, increasing their effective taxes on the sales. It might be better to spread the sales over several years if possible.

Make gifts of gains, but not losses. You can give investment assets to family members and have them sell the assets. This could reduce the family’s taxes when the person receiving the gift, usually a child or grandchild, is in a lower tax bracket. The tax rate on long-term capital gains might change from 20% to 10% or even 0%. (The person receiving a gift has the same tax basis in the asset that you did, so he or she will have the same capital gain as you would when selling the asset.) You want to be sure that the person receiving the gift isn’t subject to the Kiddie Tax, which would make the gain taxable at their parent’s top tax rate instead of the child’s. See our May 2016 issue for details about the Kiddie Tax.

You don’t want to give an asset that has declined in value. The recipient’s basis will be the lower of your cost and the current fair market value. That means no one would deduct the loss in value that occurred while you owned the asset. It’s better for you to sell the asset and deduct the loss on your return. Then, you can give the sale proceeds or something else.

Give an appreciated asset to charity. When you make charitable gifts anyway, consider donating an appreciated asset instead of cash. You’ll be able to deduct the fair market value of the asset on the date of the gift. Plus, you won’t owe any capital gains taxes on the appreciation that occurred while you owned the asset. Giving an appreciated asset is likely to generate more benefits than writing a check to charity. Different ways of donating appreciated assets to charity are in this month’s Estate Watch.

Hold for life. When assets are inherited from a taxable account, the heir increases the tax basis to the fair market value as of the date of the previous owner’s death. No capital gains taxes are imposed on the appreciation that occurred during the previous owner’s lifetime. With the federal estate tax not applying to most estates, a good strategy for highly appreciated investments is to continue holding them so the next generation can inherit and sell them without incurring any taxes.

Balance taxes and market volatility. Many people with appreciated investments often are in a conundrum. The price reaches a point where there isn’t a margin of safety. But the investors are hesitant to sell, because they know part of their gains will be reduced by taxes.

Here’s a process for making the decision. Determine the percentage of the investment’s current market value the taxes on a sale would be and compare the tax cost of selling to the potential market risk of not selling. For example, Max Profits owns a stock worth $100,000 that he purchased years ago for $10,000. His long-term capital gain is $90,000. If he sold, he would be in the 20% capital gains tax bracket and would owe $18,000 in taxes. That is 18% of the current market value and would be his guaranteed “loss” to taxes if he sold.

If Max believes there’s a high probability the stock will decline more than 18% and the decline won’t be temporary, then it makes sense for Max to sell now, pay the tax, and invest the remaining $72,000 in another investment or hold it in cash. But if Max thinks there’s a low risk of a greater than 18% sustained market decline, then the tax cost is greater than the market risk.

Another way to evaluate the issue is to look at investment alternatives. Suppose Max believes the investment is fully valued or overvalued. He would take an 18% tax loss to exit the investment. He should consider how long it would take other investments to make up that 18% loss, plus whatever additional appreciation or income he would have earned from holding the stock.

There’s uncertainty in this method, because we don’t know the returns each of the investments will generate. But this process requires us to consider the key factors in the decision and take hard looks at both the current and potential investments.

Considering taxes along with investment factors can increase your after-tax investment returns each year. Instead of waiting until near the year’s end as many people do, next year consider these strategies whenever an investment makes a significant move up or down. Determine if the move created an opening for one of these tax-saving strategies.

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