Higher taxes on long-term capital gains now occupy a prime position on the agenda in Washington. There are proposals to increase the top tax rate on investment gains to as high as 39.6% from the current 20%. Taxpayers subject to the net investment income tax pay another 3.8% currently and would continue to pay that after any of the proposed increases are enacted.
Most of the proposals limit the higher capital gains tax rates to upper income taxpayers. The President’s proposal would impose the higher rate on those with incomes above $400,000.
It’s too early for most people to take action based on the proposals. There might not be enough support in Congress for one of them to pass, or the new rate might be lower than the 39.6% that’s been proposed. It’s also too soon to guess the income level at which a higher rate would be effective.
But it’s not too early to plan what you might do and be prepared to initiate the plan should one of the proposals develop traction in Congress. Owners of appreciated assets that take a while to sell, such as small businesses and real estate, should consider starting the sale process now and being able to close before the end of the year. The higher your income is the more likely you are to face a higher capital gains tax rate after 2021 and the more it makes sense to consider options for any highly-appreciated assets in taxable accounts.
The simplest and most obvious action is to sell soon any highly-appreciated investments in 2020 to ensure gains are taxed at a maximum of 20% plus any state tax rate. Before doing so, consider all the tax implications of adding significant capital gains to your return. Doing so could push your other income into a higher bracket, trigger the alternative minimum tax, cause more Social Security benefits to be included in gross income, increase the Medicare premium surtax, or cause other changes.
The easiest and most-recommended way to avoid capital gains taxes is to hold highly-appreciated assets for the rest of your life. Have them pass to your loved ones through your estate. Under current law, the beneficiaries increase their tax basis in an inherited asset to the fair market value on the date of your death. They can sell the asset right away and not owe any taxes on the appreciation that occurred during your lifetime.
There currently are several proposals that would eliminate this step-up in basis on inherited assets or require the asset to pay capital gains taxes on appreciation that occurred during your lifetime. I think these proposals are less likely to be enacted than an increase in the top capital gains tax rate, but there’s enough support for the proposals that their enactment can’t be ruled out.
One way to protect yourself from higher capital gains taxes this year and in the future is to practice tax-wise investing.
A key rule is to limit your trading. A common mistake of individual investors is to buy and sell too often. It’s usually a good idea to avoid selling an investment until holding it for more than one year, so it can qualify for the lower long-term capital gains tax rate. Also, avoid taking too much in capital gains in one year to avoid getting pushed into a higher tax bracket. Of course, investment fundamentals are more important than taxes. But know the tax effects before selling an investment.
Another important rule is to look for paper losses in your portfolio whenever you recognize capital gains. Sell the losing investments so the losses will offset some or all of the gains. In fact, it’s a good idea to take those paper losses even when you don’t anticipate having long-term capital gains for the year. Up to $3,000 of capital losses that exceed capital gains can be deducted against other types of income, and the capital losses that aren’t used in the current year can be carried forward to future years.
Another strategy that might be viable as part of your estate planning is to give appreciated investments to family members who are in lower tax brackets. They could sell the assets and incur lower capital gains taxes. That increases the family’s after-tax wealth.
When you’re charitably inclined, there are several charitable giving strategies that can help you avoid or limited capital gains taxes.
Instead of selling an appreciated assets, you can contribute to charity an investment with long-term capital gains. You won’t owe any capital gains taxes on the appreciation that occurred during your lifetime. The charity won’t owe taxes either, because it’s tax-exempt. But you receive a charitable contribution deduction equal to the value of the investment on the date of the contribution. The charity can sell the investment at any time without owing any taxes, because it is tax-exempt.
Another strategy is to donate appreciated property in return for a charitable gift annuity. You’ll receive a charitable contribution deduction in the year of the donation for part of the current value of the property. The amount of the deduction will depend on your age and current interest rates. In addition, the charity will pay you income for the rest of your life, or the joint life of you and your spouse. The appreciation on the donated property won’t be taxed.
Or you can contribute appreciated investment property to a charitable remainder trust. Again, you’ll receive a charitable contribution deduction for part of the investment’s value and won’t owe taxes on the capital gains. The trust will pay you income for life. You decide whether the trust will pay you a fixed amount each year or a percentage of the trust’s value. The charity receives whatever’s left in the trust after you pass away.
A noncharitable strategy that’s especially useful for sales of small businesses and commercial real estate is the deferred sales trust. In this strategy, you can negotiate a sales of the property to a third party. But you sign a contract with a trust and sell the property to the trust in return for payments over time. The trust then can sell the property to the buyer with whom you negotiated.
When done correctly, you are taxed on the gains from the sale only as payments are received from the trust instead of in one year when the assets is sold. But the trust receives a lump sum payment from the buyer, so the sale proceeds are in the trust and can be invested by the trustee.
It’s important to work with an attorney who knows the details of an effective deferred sales trust. For a deferred sales trust to be effective, among other things it needs an independent third-party trustee and you can’t have access to the assets before an installment payment is due.