In speaking with our clients, one of their most common questions is about how they can reduce their tax burden. Nearly everyone believes they pay too much in taxes. However, there is a wide variety of different types of tax, including income tax, estate and gift tax, property tax, corporate tax, and sales tax. Each has its strategy for reducing the amount owed. In this article, we are focusing primarily on how to reduce your capital gains tax.
What is the Capital Gains Tax?
Capital Gains Tax is a tax assessed for the sale of an asset above its tax basis. Basically, you are responsible for tax on the difference between the amount sold and the amount paid for an asset.
To determine capital gains tax, you must first determine your cost basis in the specific asset. The cost basis is generally the amount for which you purchased an asset. For example, if John buys 200 shares of ABC Corporation for $10,000, John’s cost basis in the 200 shares is $10,000. If John would later sell the 200 shares for $20,000, then John would owe capital gains tax on the $10,000 gain ($20,000 minus $10,000 = $10,000).
Next, you’ll determine your tax rate. Much like income tax, your capital gains tax rate depends on your taxable income and tax bracket in the year you sold your asset. Your capital gains tax rate will be between 0% and 20%.
How Can I Reduce Capital Gains Tax?
The most common way to reduce or eliminate capital gains taxes is by not selling a capital asset. As mentioned above, the capital gains tax only applies to the sale of the capital asset. If there is no sale, then there is no capital gains tax. However, there are other rules for disposing of an asset other than selling.
What Happens When I Give Assets Away?
If you give an asset away, there is a concept called carry-over basis, where the person who receives the asset will receive the same cost basis that you held in the asset. For example, if John gives his son Ben the 200 shares of ABC Corporation, then Ben’s cost basis for determining capital gains taxes would be $10,000—the same cost basis that John has for the 200 shares. Therefore, when Ben sells the 200 shares for $20,000, Ben’s capital gains tax liability will be based on the $10,000—just as it would have been if John had sold the 200 shares.
However, there is also a term called step up in cost basis, where the cost basis is stepped up to the current value. The most common occurrence for the step up in cost basis is when an asset transfers at death.
In using the example above, if John transfers the 200 shares to Ben in his will or Trust — instead of gifting the shares — Ben’s cost basis in the 200 shares would be the value of the shares on the date of John’s death, as opposed to the amount for which the shares were purchased. Therefore, if Ben sold the shares immediately after John’s death, Ben would not owe any capital gains taxes because the cost basis and sale price would be the same.
Other Strategies for Reducing Capital Gains Tax
In addition to transferring assets in a will or Trust, there are a variety of other strategies that you can use to defer and avoid capital gains tax. Additional strategies include:
- Using a Charitable Remainder Trust
- Using a 1031 tax-deferred exchange
- Offsetting your gains with other capital losses
What is a Charitable Remainder Trust?
A Charitable Remainder Trust is an irrevocable trust in which a person (the donor) can transfer assets in a Trust for a specified period and then distribute the remainder to charities established in the trust agreement when the specified period ends.
Charitable Remainder Trusts can be a good strategy to avoid, reduce, and defer capital gains taxes on appreciated assets while providing for a charitable organization. Gifts made from a Charitable Remainder Trust can also be claimed as a charitable tax deduction in the year the donor transfers the assets to the charitable remainder trust.
How Can I Use a 1031 Tax Deferred Exchange?
Another strategy includes using Section 1031 of the Internal Revenue Code and engaging in a 1031 tax-deferred exchange. This strategy defers the capital gains tax to a later date. However, this only applies to tangible assets like vehicles or real estate and must be used for business or investment, not personal use.
As a general rule under the 1031 tax-deferred exchange, you will not incur capital gains tax if you purchase a replacement asset with the proceeds from the sale of another asset of the same kind. For example, you buy one real estate property with the money from the sale of another.
You must meet several considerations to qualify for a 1031 tax-deferred exchange, and doing so requires a great deal of planning. We suggest speaking to a tax attorney before selling your asset if you want to use this strategy to reduce your capital gains tax liability.
How Can I Offset Gains with Other Capital Losses?
A capital loss is when you sell an asset for less than what you originally paid for it. You can reduce your capital gains tax liability by deducting capital losses on your federal income tax return as long as your losses occurred in the same tax year as the sale of your appreciated asset.
When planning to offset your capital gains with capital losses, it’s important to note that under current IRS rules, you can only deduct a maximum of $3,000 of capital losses in any tax year.
Planning Ahead with a Tax Attorney
Reducing your capital gains taxes can take a lot of planning because so much is based on when you sell your asset, and the legal strategies for reducing tax liability can be complex and confusing. Many people inadvertently make decisions that expose them to unnecessary taxes. So, working with a trusted tax attorney and starting the process early can be a tremendous advantage.