As an economic incentive for individuals to save and invest, gains from the sale of capital assets held for at least one year unless offset by losses, as well qualified dividends received during the year, may be taxed at rates lower than ordinary income tax rates. The tax rate on long-term capital gains and qualified dividends for individuals is 20 percent, 15 percent, or 0 percent depending on their income tax bracket.
The current zero, 15 percent and 20 percent rates (28 percent for collectibles) on long-term capital gains will not change under tax reform. HR 1, the Tax Cuts and Jobs Creation Act, however, does make provision to integrate these rates into the new tiered ordinary income rate structure. The Senate version, for example, provides that the 15-percent long-term capital gain rate would begin in the case of a joint return or surviving spouse, at the $77,200 income level, and the 20 percent rate begins case of a joint return or surviving spouse, at $479,000. Short-term gains would be taxed at the new, ordinary income tax rates. Year-end tax planning for capital gains –whether or not tax reform legislation passes –should therefore follow many of the time-tested techniques used in the past, with some deference to accelerating some short-term capital gains to 2018.
Where to Start
Year-end planning for capital gains should start with data collection and a review of prior year returns. This includes losses or other carryovers, estimated tax installments, and items that were unusual. Conversations about next year should include review of any plans for significant purchases or dispositions, as well as any possible life cycle plans.
When making investment decisions, economic factors in the market should take priority over tax considerations. Taxpayers should not hold assets simply to avoid paying tax on any gain. Similarly, taxpayers should not sell assets just to take a tax loss if the asset will rise in value. Only after the economic factors are considered, should taxpayers consider the tax consequences.
Most types of nonbusiness property used for personal or investment reasons, such as stocks and bonds, are capital assets. As noted above, to receive the lower tax rate on capital gains, taxpayers must hold these investments for more than one year. The gain from the sale of capital assets held for one or less are ‘short-term’ capital gains are taxed at ordinary income tax rates. In addition, the long-term capital gain rates do not apply to all types of capital assets. A 28 percent rate applies to long-term gains from collectible and small business stock, while a 25 percent rate applies to unrecaptured Code Sec. 1250 gain realized on the sale of depreciable real property.
Comment. Generally, holding capital assets for more than 12 months before taxable disposition to avoid short-term capital gain status is advisable, unless sufficient loss offsets have been recognized, or market conditions indicate otherwise.
Generally, taxpayers must offset their capital gains with capital losses before applying the tax rates. Thus, cashing out stock and bonds with a built-in loss can be a simple means of providing a loss to be taken against income. If capital losses exceed capital gains for the year, individuals are only allowed to deduct up to $3,000 of the losses, whether net long-term or short-term capital gain against ordinary income. Any capital losses above $3,000 must be carried over and deducted in succeeding years.
As a result of the netting of capital gains and losses, taxpayers have an opportunity to minimize their tax liability by timing when the gains and losses occur. For example, a taxpayer could sell capital gain property before the end of the year if they have already realized capital gain losses during the year. Also, if allowable deductions for the year will exceed income, taxpayers should try to avoid realizing any additional capital losses during the year as they would be worthless or have to be carried over to the next year.
“Wash” sales. Taxpayers may want to recognize capital losses for tax purposes on stock or securities without completely abandoning their investment. One technique for maintaining the investment is to sell the stock or security at a loss, and then buy the same stock or security. The ‘wash sale’ rules, however, prevent taxpayers from claiming any loss from these types of transactions if they acquire substantially identical stock or securities within 30 days before or after the sale.
Comment. The wash sale rule can be avoided by simply waiting 31 days before purchasing substantially identical stock or securities. Even if taxpayers violate the time limits of the wash sale rule, the disallowed loss is not lost. Instead, the loss is added to cost of the new stock or securities acquired. Plus, the holding period of the new stock or securities includes the time taxpayers held the stock or securities sold for a loss.
Other Timing Rules
When dealing with capital gains, the greatest flexibility taxpayers have comes from their ability to decide when to sell assets. For example, taxpayers may know they will be in a higher income tax bracket in 2018 that would subject them to a higher capital gains rate. As a result, they could sell investments in 2017 to generate long-term capital gains to take advantage of a lower capital gains rate. In other words, spreading the recognition of income between multiple years may help minimize the total amount of tax paid in those years.
Comment. The zero percent capital gains rate creates a planning opportunity, particularly within intra-family situations. Appreciated property may be gifted to a low-bracket individual, with the gain on a subsequent sale then taxed at a zero rate to the extent that gain on top of other income does not exceed the top of the 15 percent bracket. Certain restrictions must be respected, however, including not contravening the kiddie tax rules, not exceeding the annual gift tax exclusion, and not setting up a structured transaction in which the sale after the gift has been prearranged.
Net Investment Income (NII) Tax
In addition to regular income tax liability, many individuals may be surprised to learn that they may be subject to an additional 3.8 percent tax on net investment income (NII). Recent run ups in the financial markets have increased the need to implement strategies that can avoid or minimize this tax. The NII tax is part of the Affordable Care Act and, therefore, will not be repealed under current tax-reform efforts. At least for 2017, taxpayers with income above the $200,000 threshold ($250,000 for joint filers) should assume that their net capital gains, whether long term or short term, will be subject to the additional 3.8 percent tax.