Plan Ahead to Reduce Capital Gains Taxes

March 27, 2013

What are capital gains? They typically are profits made from the sale of property that is a capital asset.

For individuals, gains from the sale of capital assets – such as stocks, bonds, real estate or collectibles – are generally taxed more favorably than those gains from the sale of an ordinary asset.

However, short-term capital gains – resulting from sales of properties held for a year or less – are taxed at a higher rate. Consequently, it is important to consider the holding period when you are planning to reduce your tax on capital gains.

Capital gains are generally defined as the excess of the sales price of the investment over its “basis,” the purchase price, plus associated purchase costs.

Basis is determined by how the investment was acquired. For instance, if you:

• Purchased the investment, then the basis is what it cost you.
• Received the investment as a gift, then the basis is the cost of the investment paid by the one you received it from, unless the investment was worth less than the original price when it was given to you.
• Inherited the investment, the basis is the value of the investment on the date that the person you inherited it from died.

The best way to minimize your tax from capital gains is to do some tax planning. Here are two general strategies, but it is always best to consult your tax adviser:

• Hold investments for over a year before selling them.
• Consider selling investments with capital losses to offset capital gains.

When do you pay capital gains taxes?

Capital gains are not taxed until the assets have been sold. So, no matter how much your properties may have appreciated, capital gains tax is not imposed until the gains have been “realized” from a sale or exchange.

The IRS cannot tax unrealized capital gains. The capital gains tax is imposed, generally, from the actual collection of these gains.

How do capital gains for dealers differ?

If your business is dealing in land or stocks, for instance, these assets are not considered capital gains property. They are ordinary income tax property.

There have been many tax cases dealing with whether someone’s activity is that of a business or of an investor to qualify the profits as eligible for capital gains treatment.

How is dealer vs. investor status determined?

It is interesting to note that, since the economy has declined, some taxpayers are now arguing that they are in the business of dealing in property and are not investors.

Why? It’s because the property values have declined and capital losses are generally much less tax-attractive than ordinary losses. After offsetting any capital gains, capital losses can only be deducted against ordinary income up to $3,000 per year (with a carryover of the excess to future years). Ordinary losses, on the other hand, can offset ordinary income without limitation.

This dealer versus investor status is not just a choice. It really depends on what you were doing with the assets and, sometimes, what your intent was. Investors are generally those who have limited transactions for their own purposes, whereas dealers regularly buy and sell assets to customers in the ordinary course of business. You can see how this is not a “bright line” test.

What are capital gains tax rates today?

Favorable capital gains rates have been around for many years, and there have been many variations. The intended purpose of better rates on capital gains is to stimulate investment and fund entrepreneurial activity. However, for some “higher income” taxpayers, capital gains rates have increased this year due to the American Taxpayer Relief Act of 2012.

So, how favorable are capital gains? Gains from the sale of capital assets held for longer than a year, “long-term capital gains,” are still taxed at a maximum rate of 15 percent for many taxpayers. However, for tax years beginning after 2012, a new 20 percent tax rate will apply to dividends and long-term capital gains for married taxpayers with taxable incomes exceeding $450,000 ($400,000 for single taxpayers) to the extent these gains and/or dividends exceed these threshholds.

For taxpayers between the 25 percent and 39.6 percent brackets, capital gains and dividends will continue to be taxed at 15 percent, while the lower bracket individuals will still enjoy a zero percent tax rate.

That same income, if not for long-term capital gains rates, could be taxed as high as 39.6 percent. Also effective in 2013 are the new Medicare taxes. One of these additional taxes is called the unearned income Medicare contribution tax and was enacted as part of the healthcare reform laws. This additional tax of 3.8 percent can apply to capital gains.

Sales of collectibles such as antiques, stamps, gems, coins, etc., are taxed at a different capital gains rate. Generally, these capital gains are taxed at a maximum rate of 28 percent if they are long-term gains or at the ordinary income tax rate if they are short-term gains.

For some who still may be lucky in the housing market, some profits from the sale of your home may be taxed at capital gains rates. When you sell your primary residence, you can take $250,000 tax-free if you are single and $500,000 if you are married. Profits above these caps are taxed as capital gains.

A note on what may seem like capital gains but, unfortunately, are not: Profits from the sale of investments held in a traditional IRA or a 401(k) plan, even if these assets are otherwise capital assets, are taxed as ordinary income when distributions are made. This is true because of the rules regarding retirement plan contributions and distributions.

Many taxpayers who realized substantial gains in their retirement plans had expected to pay favorable capital gains rates and were very disappointed to find this advantage was not available.