This is the second in a series of posts addressing year-end tax planning topics for 2016. Topics addressed in this post deal mostly with various capital gain issues. As with any tax planning or strategy, whether an idea would be beneficial for you depends entirely on your particular facts and circumstances – therefore it’s important that you talk with someone knowledgeable before proceeding.
Taxation of capital gains – the basics
Taxpayers with net long-term capital gains for the year enjoy the benefit of a lower tax rate on those gains. Long-term capital gains are gains from the sale of capital or investment assets held longer than one year. Short-term capital gains are gains from the sale of property held for one year or less. Long-term capital gains (and “qualified dividends”) are taxed for federal income tax purposes at a top rate of 15% for single filers with taxable income up to $415,050 ($466,950 for those filing as married filing jointly) and at a rate of 20% for taxpayers with incomes higher than those thresholds. Different rates apply to gains from “collectible” assets or depreciation recapture. There is a separate 3.8% surtax to fund the Affordable Care Act passed in 2010 that is applied to net investment income for taxpayers with adjusted gross income over $200,000 for single filers ($250,000 for those filing as married filing jointly).
How is the net capital gain determined?
The first step in determining the character of your capital gains is to net all short-term gains and losses (arising from assets held one year or less), and then separately, to net all long-term gains and losses.
If both short-term activity and long-term activity result in losses, the losses are kept separate and the overall capital loss deduction allowed is $3,000 (any excess can be carried over to future years).
If both short-term activity and long-term activity result in gains, the short-term gains are treated as ordinary income subject to tax rates just as any other income, the long-term gains are subject to the lower rates described above.
If a taxpayer has net short-term losses and net long-term gains (or vice versa), the two are netted. If the result is a net short-term gain, the net is treated as ordinary income as described above. If the result is a net long-term gain, the net is treated as a long-term gain, subject to tax at advantageous rates.
Tax loss harvesting
As the year end approaches, sharp investors will evaluate the capital gains and losses they’ve already recognized so far this year. If the result is a net short-term gain, one planning strategy is to look at remaining stock positions that have built in losses that have not yet been recognized because they still hold the stock. “Harvesting” the losses by selling the stock, especially if the losses would be short-term, is one way to reduce the amount of income subject to tax at ordinary income rates (i.e., short-term gains). However, this is definitely an area where you don’t want to let the tax strategy be the sole determining factor – if you think the stock is otherwise a good investment, especially if you think it’s poised to move upward soon, you may want to hang onto that stock. Especially since the tax code provides special rules where taxpayers sell a stock to realize a loss and then repurchase the stock within 30 days (the “wash sale” rules). Wash sale rules require the taxpayer to defer the gain until the repurchased stock is sold. Sounds complicated? Yes, this would be a good time to talk to a professional.
Avoiding capital gains tax entirely?
What if you’d like to avoid incurring a capital gains tax on the sale? One idea, discussed in the last post on year-end planning, explained the strategy of making charitable contributions with appreciated publicly traded stock. Another idea is to gift appreciated stock to college age children and have them sell the stock. If their taxable income is under $37,650 (assuming they are single), they can sell stock with long-term capital gains and pay tax at a rate of 0%. Gifting strategies can be very complex, but if you have college age kids and you’re paying for some or all of their college expenses, this might be a very good strategy.
Mutual fund year end distributions
Towards the end of the year, investments in mutual funds often result in substantial distributions of accumulated trading gains incurred inside the mutual fund during the year. If you’re planning on investing in mutual funds between now and year end, make sure you discuss with your broker what the anticipated capital gains distributions typically are in that fund, and what portions might be long-term versus short-term. The gains distributed are taxed to the person holding the mutual fund shares on the date of the distribution – they aren’t prorated to reflect ownership during the year. For example, if you bought the mutual fund shares the day before the distribution, all of the gains that the distribution represented would be taxed to you, irrespective of your short period of ownership.
In the next year-end planning post, we’ll talk about planning ideas related to stock-based compensation (Incentive Stock Options, non-qualified stock options, restricted stock grants).
As always – let us know if you have questions or want to see something specific addressed.