Following are the BASICS of capital gains as they pertain to the investments we typically encounter. You should consult with your tax professional for your personal situation.
What are capital gains (and losses)?
You buy XYZ Company stock for $10 per share. You need money later, and sell the stock at $12 per share. You now have a capital gain of $2 per share. This is how capital gains (or losses if you sell for less than the cost) are generated in most cases for any asset (i.e., stocks, bonds, mutual funds, real estate, etc.). Note that you don’t have a gain until you actually sell the asset. When you sell, the gain is realized and might be taxed. If you haven’t sold the asset the gain is unrealized and therefore not taxed.
Are they taxed, and if so, how?
Currently, the federal capital gains tax rate ranges from 0 – 20%, depending on your other income. Another factor that affects how you are taxed is whether you have held the asset for more than a year (long-term gain) or less than a year (short-term gain). In most cases the short-term gains are taxed at your income tax rate (these range from 10% to 37%), and not the lower capital gains rate. Here’s another important issue: Your capital gains could affect the taxes on your other income and even your Social Security payment by pushing you into a higher bracket. Again, each person’s situation is unique, so consult your tax professional.
Is there a way to “manage” capital gains to be tax efficient?
The good news is that yes, there are a few basic things that should be done to manage your gains and losses to be more tax efficient:
- If you have gains already realized, then look for losses to take against the gains. You can offset realized short AND long-term gains with losses on similar types of assets.
- You can also time your gains so that you take, for example, half of the gains at the end of the year, and then take the other half at the beginning of the next year.
- If you have assets that you have not sold which have high unrealized gains, and you don’t need to sell them, then depending on your age and health you may simply want to allow your heirs to inherit these assets. There is a “step-up” of the cost basis if you die with the asset in your name. Therefore, your heirs will have an asset that has no inherent capital gain for tax purposes. Obviously, the risk here is that the asset value may drop while you hold it.
- Finally, you may have an insurance policy with insufficient or outdated benefits or real estate assets and need to improve them or sell them, but don’t want to pay taxes on the gain at this time. If you don’t expect to need the money for a while, then doing a tax-free exchange may better suit your needs.
These are the basics. Please feel free to call with any questions regarding your specific situation.
by Ronald Donato, Jr., CFP®, MBA
Director of Financial Services