The right timing can result in significant tax savings.
If you plan to sell capital assets, a little planning can do wonders for your tax bill. Capital assets include a wide range of property held for personal or investment purposes, including stocks, bonds, real estate, jewelry and collectibles. Here are a few rules of thumb that may reduce your capital gains taxes.
Avoid short-term gains
For tax purposes, capital gains are treated differently based on how long you’ve held an asset. Short-term gains (on assets held for one year or less) are taxed at ordinary income rates (currently as high as 37%), while long-term gains (on assets held for more than one year) generally are taxed at a favorable 15% rate. There are some exceptions: Taxpayers in the lowest two tax brackets qualify for a 0% rate, while certain high-income taxpayers are taxed at 20%.
Also, net capital gains on collectibles — such as art, antiques, precious metals, stamps, coins and gems — are taxed at a maximum rate of 28%. Gains attributable to depreciation of real estate are taxed at a maximum rate of 25%.
Finally, be aware that if the net investment income tax applies, your gains may be subject to an additional 3.8% tax.
Consider the timing of the sale
If you plan to sell a capital asset at a gain, it’s generally preferable to wait until you’ve held it for more than a year to take advantage of the favorable long-term capital gain rates. But if you’re considering selling it at a loss, the timing of the sale is critical.
Under certain circumstances it may be preferable to make the sale before you’ve held the asset for more than one year. Why? Because when you determine your net capital gain or loss in a particular year, the first step is to offset gains and losses of the same type — that is, short-term losses against short-term gains and long-term losses against long-term gains.
Consider this example. So far this year, Jim, who’s in the 32% tax bracket, has recognized $5,000 in short-term capital gain and $5,000 in long-term capital gain. If he doesn’t sell any more capital assets this year, the short-term gain will be taxed as ordinary income and the long-term gain will be taxed at 15%.
Jim also owns stock, purchased on September 1, 2021, which has declined in value by $5,000. If he sells the stock by September 1, 2022, it’ll generate a $5,000 short-term loss that will erase his $5,000 short-term gain, leaving him with the lower-taxed long-term gain of $5,000. However, if Jim waits until after September 1 to sell the stock, the sale will generate a long-term loss, which must be offset against the long-term gain, leaving him with $5,000 in short-term gain taxed as ordinary income.
From a tax planning perspective, it’s usually best to recognize both capital gains and capital losses in the same tax year, since the losses can be used to offset the gains, reducing your tax bill. But there may be situations in which it’s preferable to postpone gains until the following year. That’s because you’re permitted to deduct up to $3,000 in net capital losses from your ordinary income (such as wages and interest).
For example, let’s say you have a $3,000 net capital loss this year, and you’re also contemplating selling stock that would generate a $3,000 long-term capital gain. If you sell the stock this year, the gain will offset the loss, and you’ll lose the $3,000 deduction from ordinary income. But if you wait until next year to sell the stock, you’ll preserve the $3,000 deduction, reducing this year’s tax bill.
Sell highest-cost shares first
If you plan to sell shares of stock or other securities that you purchased at different times for different prices, you can generally lower your taxes by selling the shares that will produce the smallest gain or largest loss. When you sell securities, by default, brokers often apply the first-in, first-out accounting method, which assumes that the first shares purchased are the first shares sold. Often (but not always) those shares have a lower cost-basis, increasing your taxable gain.
If possible, ask your broker to use the specific identification method. This allows you to minimize your taxes by instructing the broker to sell the shares with the highest cost basis.
Look before you leap
Be sure you understand the tax consequences before you sell any capital assets. Often, even small changes in the timing of a sale can mean big tax savings. Your tax advisor can help determine the right course of action considering your overall financial plan.