If you are an investor with highly appreciated assets such as real estate, a business, stocks, or cryptocurrency, it is essential that you understand your capital gains tax liability.
Capital gains are the profits made from selling an asset, the difference between the purchase and selling prices.
Capital gains taxes are the taxes levied by the federal and state governments on the profits you make from selling an asset.
Federal capital gains taxes are calculated based on your profit, how long you’ve held the asset, and your income level. Some states also levy an additional capital gains tax, and the tax rate depends on the state. For high earners in states such as California, you can expect to owe up to 35% of your profit in capital gains taxes.
Because capital gains taxes can account for a third of your overall proceeds, careful tax planning is non-negotiable. Experienced capital gains tax advisers can help you leverage strategies to reduce or defer your capital gains tax, maximizing your returns.
Before you start thinking about selling a highly appreciated asset, here are seven common capital gains tax mistakes you should avoid if you want more money in your pocket and less going to Uncle Sam.
1. Selling Before the One-Year Mark
As we said before, capital gains taxes are calculated based on how long you have held an asset. Whether your investment is property, a business, art or collectibles, Bitcoin, or stocks, purchasing and selling your asset within the same year is considered a short-term investment. Short-term investments are taxed as ordinary income, and the federal income tax rate for the highest earners is 37%.
Any asset you have held for longer than a year is considered a long-term investment and is taxed at the capital gains tax rate. Capital gains are taxed at 0%, 15%, and 20% based on your income level.
Because of the difference in tax rates, selling before the one-year mark will cost you at least 15%. Unless you are getting a great deal, you should wait to sell until you can take advantage of the lower long-term investment rates.
2. Not Taking Advantage of Capital Losses
The federal government allows investors to offset up to $3,000 yearly in capital gains losses. This means that if you have an underperforming stock, you can sell it at a loss and use that loss to offset some of your capital gains and reduce your tax liability.
3. Donating Cash Instead of Stock
If charitable giving is important to you, don’t make the mistake of selling an asset and then donating the cash to charity. You’ll be stuck paying capital gains taxes on your profit before you donate. Instead, donate the appreciated stock or asset directly. You can avoid the capital gains tax on that appreciated asset AND get a charitable contribution tax deduction.
4. Holding a Bad Investment Just to Avoid Capital Gains Taxes
Good investing is more important than avoiding taxes. If you have a stock you no longer believe in, don’t hang onto it just to avoid taxes. You have to take a big-picture view of your investments to get the most out of your returns. A capital gains tax consultant can help you determine when it is worth hanging onto an asset and when to cut your losses and sell.
5. Overlooking State Tax Planning
Don’t forget to consider the state capital gains taxes you might owe when you are doing your tax planning. Not every state has capital gains taxes, but capital gains rates can almost double your tax liability in other states. State taxes must be an integral part of your overall tax strategy.
6. Failing to Harvest Gains
Timing is a crucial part of long-term tax planning. It might make more sense for you to pay more in taxes now to avoid higher tax rates in the future. For example, if you are currently in a lower income bracket, you can sell a highly appreciated asset and pay a 0% or 15% tax rate today rather than a 20% tax rate in the future when your income increases. Failing to harvest gains when you are in a lower-income tax bracket can cost you more in taxes in the long run.
7. Not Using a Tax Professional
If you are exiting a business, preparing to retire, selling appreciated real estate, or planning your estate, a tax professional can save you thousands of dollars. A capital gains tax advisor has the experience, knowledge, tools, and resources to implement wealth management strategies such as using tax-advantaged accounts, harvesting losses, 1031 exchanges, charitable trusts, or Deferred Sales Trusts.
Instead of thinking of hiring a capital gains tax consultant as a cost, consider it an investment. You will end up with a more secure financial future and more money in your pocket when you work with a professional to create a long-term capital gains tax strategy.
Tax planning doesn’t have to be overwhelming. Carefully considering your overall tax strategy, the timing of your sale, and opportunities for reducing or deferring your capital gains taxes can help you maximize your returns and grow your wealth.
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Infographic
If you own appreciated assets like real estate, stocks, or cryptocurrency, understanding capital gains tax liability is crucial. Before selling, take a look at this infographic to uncover seven common mistakes to avoid and ensure you keep more money in your pocket.
