When you sell an investment for more than you paid for it, the difference is called a capital gain. If the investment was held for more than one year, the gain is considered long-term and is (typically) taxed at a lower rate than regular income. There are many ways to defer, manage, or avoid paying capital gains taxes on investments. In this blog post and the following one, we will explore several of those options and discuss the pros and cons of each one.
Do Your Math Right
First, you need two pieces of data when you’re calculating your capital gain.
1. Basis. Define basis as what you paid for the investment, plus any associated costs of purchase, like commissions. This can also include upgrades, like on the real property.
2. Sales Price. This is how much you sold the investment for minus any transaction costs, like commissions.
From these two numbers, you subtract your basis from your sale price to come up with your gain or loss. If the number is positive, it’s a capital gain. If you’ve owned that property for more than a year and a day, it’s a long-term capital gain. Those are the gains we’re talking about in this article.
Where people make the biggest mistake:
This usually happens when there is a mortgage involved. Instead of subtracting the basis from the sales price, they subtract off the mortgage balance. This is incorrect. Now, the mortgage will factor into how much in proceeds (actual cash) one might receive after the sale, but that’s a different calculation than how much capital gain that occurred. Don’t make this mistake.
Calculate Your Taxes
Now that you know how to calculate your long-term capital gain, you need to know the tax rate. Like income taxes, the federal capital gains tax rates are progressive. Up to a certain income, you will pay no taxes. For most people, it’s 15%. However, if your income is above a certain level, it goes up.
In 2022, for individuals who earn more than $459,750 or married couples earning more than $517,200, the long-term capital gains tax rate is 20%. Capital gains tax may be subject to the net investment tax as well, which can increase the tax bill by 3.8%.
If you are in a state that taxes long-term capital gains, you will pay state taxes on top of that, with the highest amount of 13.3% in California.
This calculation typically gets people’s attention. There are ways to lower that tax bill. Here are some options.
Options for Paying, Deferring, or Avoiding Capital Gains Taxes
This blog will cover the obvious and the popular. In the next blog, we will cover the less obvious and often overlooked. These explanations are not intended to be comprehensive or exhaustive (you could write a blog to a book about any of them) but a quick taste of what you may want to explore.
1. Pay the tax.
Don’t avoid the obvious. Paying taxes is not necessarily a bad thing. Paying taxes means you made money. It’s also how we participate in civic life and contribute to society. If you don’t like how your tax dollars are spent, vote and become more active in government.
Arguably, taxes of all kinds are on sale right now. Proposals for increasing capital gains taxes — by increasing the tax rate, marking to market, eliminating the step-up in basis rule, etc. — are becoming more frequent. At some point, our government(s) are likely going to have to collect more taxes to meet our spending obligations.
Perhaps the smartest thing to do is to go ahead and pay the taxes now.
2. Move and pay the tax.
If you are in a high capital gains tax state like California, you could explore a low capital gains income tax state like Wyoming. Move, establish residency, and then dispose of your highly appreciate asset and pay the taxes.
Keep in mind the bigger picture. Remember that the step-up in basis rule allows your heirs to receive an inheritance after your death and take property with a basis that equals the value on the day of your death. Your heirs can sell at that point and pay no capital gains taxes. Dying owning an asset might also be the best way to manage a potential tax liability for your heirs. This won’t help you, but it will help your family, and if that is your intention, keep this option on the table.
Sometimes, waiting for someone to die seems like not an option, for instance, when an elder needs money for assisted living expenses. Make sure you explore other options before selling an asset with a low basis like some of these below and/or a reverse mortgage.
4. The 1031 Exchange
Probably the most well-known go-to solution for deferring capital gains taxes, this is when an owner sells an investment property and reinvests the proceeds in a similar property and defers paying capital gains taxes until the last exchanged property is sold. It is named after the section of the tax code that governs it, also called a Starker exchange or a Section exchange.
How it works:
When the property is sold, the proceeds go to a qualified exchange accommodator. The seller only pays taxes on what the seller ACTUALLY receives. If the exchange accommodator holds 100% of the proceeds, the seller receives nothing and pays no tax at that time. The seller then identifies a property to buy, and those proceeds are applied to that purchase.
The tax savings can be significant, especially since these exchanges tend to go on for decades. It allows the owners to upgrade to more appealing properties.
There are rules to follow. For instance, the seller has 45 days from the sale of the first property to identify replacement property or properties and 180 days from the date of sale to close on the replacement property or properties. This can be tough in some real estate markets.
The replacement property must also be “like-kind.” That generally means investment or business real estate held for productive use in a trade or business or for investment. So, you couldn’t exchange your rental house for a vacant lot, but you could exchange one rental house for another. Pretty much only real estate is available for the 1031 exchange. For instance, it no longer applies to selling one business and buying another.
Who likes 1031s:
Investors who know and love real estate. Those who want to get out of the real estate and invest in a Delaware Statutory Trust (DeST).
Who tends not to use 1031s:
Investors who want out of the business of owning and managing real estate.
5. The Installment Sale
Perhaps the second most well-known go-to solution for deferring capital gains taxes, this strategy sells the property to a buyer who will pay for it over time in installment payments. As the seller receives payments, the seller pays taxes on what has been received.
How it works:
The seller and buyer create an agreement for the buyer to own the property and the seller to receive regular installment payments over a period of years.
Because the seller is not receiving all the proceeds at once, the seller can manage the tax implications over time. More buyers can likely afford to purchase the property with this agreement because the buyer does not necessarily need to get a loan. It’s also a way for a buyer to negotiate having a seller participate in the property (like a business) so a successful transition can happen. This works well for selling businesses.
The buyer could default. The buyer could destroy the property before defaulting. The seller must wait for 100% of the proceeds. This structure will not work for some assets (publicly traded stock or cryptocurrency, for instance).
Who likes installment sales:
Sellers willing to wait on their proceeds and are confident in the buyer’s ability to repay. Sellers of businesses.
Who does not like installment sales:
Sellers who want access to more of the proceeds early and/or have little confidence in the buyer’s ability to pay over time. Investors of assets that don’t work with this structure.
6. Intermediated Installment Sale
The intermediated installment sale is when a seller sells a property to a trust, and the trust turns around and sells the property to the buyer and holds the proceeds in trust to the original seller, and agrees to pay those proceeds in installments over time. The most well-known of these is the Deferred Sales Trust.
How it works:
By selling the property to a trust and not receiving any proceeds, the seller has not taken any receipt of funds and therefore has no capital taxes to pay. As the seller receives payments in installments, the seller will pay taxes on those funds.
Installment note can be customized to the seller’s needs. More influence over how proceeds are invested. Opportunity to reinvest in real estate through an LLC structure with the trustee (much like a 1031 exchange but with no timing rules). No buyer default risk as with a classic installment sale.
No control over how proceeds are invested unless an LLC is created with the trustee to invest in real estate or a business (must be arm’s length). Success depends on how the investments perform.
Who likes DSTs:
Those who cannot use a 1031 exchange and/or don’t want the risks of a classic installment sale. Those who own real property and want to buy real property but do not want to be bound by the 1031 timing rules (sell in a seller’s market and buy in a buyer’s market).
Who does not like DSTs:
Investors who want 100% control over their assets.
In the next blog, we will cover some often overlooked options for capital gains tax management.
About the Author:
Jessica Lanning JD, CFP® brings focus and perspective to your individual financial needs to identify your opportunities for investment and wealth. Regardless of what you’ve done before or what “mistakes” you think you’ve made, Jessica can help get you back on track quickly and safely. As a former practicing lawyer, she brings a comprehensive approach to legal, tax, and financial challenges so that her clients can enjoy peace of mind. A huge proponent of conscious decision-making, Jessica makes sure her clients are educated and informed so that they make sound decisions with clarity and confidence.
Lanning Financial Inc. is a registered investment adviser. The information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.