There are many reasons you might have a large single stock holding. Regardless of the reason, a concentrated stock position is risky. You may have received shares as a part of a compensation package, or you inherited stocks. Perhaps you got lucky when you bet on an early-stage company.
If these stocks make up more than 5-10% of your portfolio, there is potential for a big payout if the stocks do well. However, it also means your wealth can be erased if that stock does poorly.
In contrast, a diverse portfolio limits the risk of a volatile market negatively impacting your investments. That’s not the only benefit. Many people ignore the “opportunity cost” of not diversifying. If all of your wealth is in one asset class, you will miss out on growth opportunities when another class of assets performs well. By spreading out your assets, you widen your opportunities for growth.
You know that “holding all your eggs in one basket” is a problem, but you might be unsure of how to go about diversifying. Particularly if you have highly appreciated stocks, you will owe a large chunk of money in capital gains taxes when you sell.
If you want to diversify but are wondering how to reduce or defer capital gains taxes on your stocks, here is your guide:
Be Charitable
If you make regular charitable contributions, you can choose to make some of those donations in the form of stocks. If you donate the stock directly before selling it, you won’t owe capital gains tax on the asset, and you will qualify for a charitable deduction for the fair market value of the stock (up to 30% of your adjusted gross income.)
Gift it to Family Members
Gifting some of your stock to loved ones is one way to alleviate the risk of holding a concentrated position. It can be part of larger estate planning, as it might reduce your taxable estate. However, it is essential to note that gifted assets do not qualify for the step-up basis given to inherited assets. That means that while you might alleviate your tax burden, you could saddle your loved ones with an increased tax liability. If your family member is in a lower tax bracket, it could still save you money on taxes.
Use Staged Diversification
One way to avoid the shock of an outsized capital gains tax bill is to use a multi-year selling strategy. By selling smaller portions of your concentrated stock each year, you can offset some of your capital gains with losses and spread out your tax burden over time. You can also slowly reinvest into a wider range of stocks, diversifying your overall portfolio.
Establish a Deferred Sales Trust
A Deferred Sales Trust gives you the tax benefits of a staged selling strategy but alleviates the risk of holding a large single stock over many years.
The Deferred Sales Trust (DST) takes advantage of IRC 453 in the US tax code. The IRS allows for installment sale trusts to defer capital gains taxes. Simply put, you sell your concentrated stock to the DST, which acts as an independent third-party trust. You will receive a secure promissory note outlining the repayment terms in return. The DST sells the stock and reinvests the proceeds according to your desires and risk tolerance. At this point, you have never taken “constructive receipt” of your profits, so you don’t owe any capital gains tax.
You will work with the Deferred Sales Trust trustee to determine how you want to reinvest your money. Your reinvestments can be as varied as you wish. You can invest in real estate, stocks, bonds, cryptocurrency, or any combination of the above. The DST won’t make any investments without your approval, and the trustee will work hard to make investments that meet your financial goals and fit within your risk tolerance.
Depending on how you structure your trust, you can choose to receive either interest-only payments or a combination of principal and interest. You will only owe capital gains tax on the portion of the principal you receive each year, while interest will be taxed as ordinary income. By opting for interest-only payments, you can delay your capital gains taxes, potentially putting you in a lower tax bracket or giving you the opportunity to offset gains with losses, reducing your overall tax liability.
Remember, if you choose to receive interest-only payments, you’ll only owe ordinary income tax on the payments received. With this payout structure, you defer your capital gains taxes since you are not withdrawing any principal.
A Tailored Approach
Remember that you can apply a combination of strategies over time to best meet your financial needs and goals. Any capital gains tax strategy must consider your timeline, risk tolerance, and estate planning desires. A Deferred Sales Trust trustee, your financial planner, and tax attorneys will work together to craft a plan to diversify your concentrated stock position while deferring and minimizing your capital gains tax liability.
It is possible to manage your concentrated stock position without losing a large portion of your profits to capital gains taxes. If you have more than $1 million in appreciated assets you want to sell, reach out to an experienced trustee to see how a Deferred Sales Trust can work for you.