Unlike the start of the last decade when stock prices were still reeling from the aftershocks of the great recession, these days many investors feel paralyzed by large unrealized capital gains that have accumulated in their taxable accounts. Let's get something straight—capital gains taxes are not voluntary. While investors control the timing of asset liquidation, an embedded liability is always present. Attempting to manage a portfolio using only a tax minimization strategy will often lead to problems including overexposure to a single company stock and a reduced ability to rebalance later in life. Considering recent tax proposals, the capital gains tax rate is not likely to decrease anytime soon, leaving seldom a reason to defer an appropriate sale. That being said, taking advantage of certain strategies may allow investors to save on taxes while simultaneously achieving a stated goal.
For those who wish to support their children financially, gifting appreciated securities may be a wise decision. The date of purchase and cost basis carry over to the recipient of the gift. It is then up to that recipient to sell or hold the asset. At the time of sale, any realized gains will be taxable to the new owner at their rate. Therefore, if a parent facing the 20% federal capital gain tax were to gift securities to their child, when a sale takes place, the child would be taxed at their lower (possibly 0%) rate. Just beware the Kiddie Tax when reviewing this strategy. Also note that any gift above $15,000 in 2021 will likely reduce your lifetime gift tax exemption.
A similar option for those who are charitably inclined, would be to gift appreciated securities to a qualified charitable organization designated by the IRS as a 501(c)(3). In applying this method, the grantor of the gift receives the current market value as a deduction, no gain is realized by the grantor, and any gain realized by the charitable organization is non-taxable. This method typically presents more benefit than donating cash. Depending on your income, there may be a limitation as to how much of the gift can be deducted. Combining gifts in one calendar year or utilizing a Donor Advised Fund could potentially provide a greater benefit.
The only method for paying no capital gains tax while also retaining ownership of an asset is to fall under certain income thresholds. Single filers with income under $40,000 and joint filers under $80,000 could end up paying a 0% tax on their gain. If income is lower in certain years, it may be advantageous to realize gains and repurchase the same security (if appropriate), effectively stepping up the basis. Similarly, if income is likely to be reduced in future years, deferring gains could make financial sense. Just be sure that tax avoidance isn't the only driver of your portfolio. Risk and performance should also play a role in the decision to hold or sell an asset.
When an individual passes away, it is likely their assets will receive a step-up in basis. This allows the beneficiary to liquidate inherited assets without facing a capital gains tax they were not responsible for creating. For those later in life, holding onto low basis property could add substantial wealth to an estate. If following this strategy, be sure to consult with a financial professional to understand more about the risks related to holding large positions in individual securities. In certain cases, it may be beneficial to utilize put options to offset risk. As always, the tax code is subject to change, President Biden's newly proposed tax plan takes aim at the step-up basis and capital gains as a whole. Read our recent blog post to learn more about the implications of the proposed plan.
In the end, there isn't a lot we can do to legally avoid taxes. However, there are certainly strategies that can be used to manage around them. Taxes alone should never dictate a decision, but it's important to always be aware of their financial impact. Keep your financial advisor and accountant in the loop on any taxable events so they can verify you're not paying the government more than their fair share.
Joe Crowley, CFP® is an Investment Advisor at Exchange Capital Management. The opinions expressed in this article are his own.