Tax Strategies – Ways to Save on Your Capital Gains
Recently, there has been increased discussion over tax rates in the U.S. following the Tax Cuts and Jobs Act of 2017. More frequently, the rhetoric coming out of Washington indicates that we could see an increase in taxes once the current legislation sunsets at the end of 2025. If that were the case, Congress could increase both ordinary income tax rates as well as capital gains tax rates.
Currently, the maximum federal capital gains tax rate is 20% for the highest marginal tax bracket, which is rather low in comparison to the effective tax rate on other sources of income such as dividends, interest, and wages. Individuals can delay realizing their capital gains, which reduces the present value of the tax burden – but if rates increase in the future, this may not always be the most effective strategy. If capital gains tax rates move up, it might make sense to accelerate capital gains rather than to delay them.
When tax deferral is desired, there are a variety of ways to delay or avoid paying capital gains taxes, which we explore in further detail below:
Exclusion for Sale of Primary Residence (Section 121 Exclusion) – Current tax code allows for a $250,000 exclusion if unmarried, or a $500,000 exclusion per married couple above your basis for the sale of your primary residence as long as you meet ownership and use tests.
1031 Exchange – A 1031 exchange can be a useful tool to defer paying capital gains on real estate assets. The exchange allows the owner of a property to exchange the asset they own for a like-kind investment. To avoid any capital gain, the new property must be of equal or greater value.
Qualified Opportunity Zone Funds (QOZ) – The 2017 Tax Cuts and Jobs Act established the Qualified Opportunity Zone program to provide a tax incentive for private, long-term investment in economically distressed communities, as determined by the Treasury Department. By using a QOZ Fund, investors are given an opportunity not only to defer taxes, but to reduce their tax on recognized capital gains if held long enough.
To defer all or part of their gain, an investor has 180 days from the date of sale to invest their gains in a QOZ Fund. Once invested, any prior taxable gain is not realized until December, 2026 at the latest. In addition to the tax deferral, an investor also receives a 10% step-up in tax basis in five years and an additional 5% step-up in basis at year seven. Note that in order to receive the full 15% step-up, the individual must have invested in the QOZ Fund prior to December 31, 2019.
In addition to the tax deferral and potential 15% step-up in basis, if the Qualified Opportunity Zone Fund assets appreciates in value and the investment is held for 10 years, the appreciation on the initial investment is also tax-free upon sale.
If Qualified Opportunity Zone Funds are of interest to you, WESCAP Group can provide you with further information regarding several offerings. Note that WESCAP Group is not affiliated with any Qualified Opportunity Zone Funds.
Step-Up in Basis at Death – If an individual owns assets that have significant capital gains, it may be prudent to plan to hold those assets until they pass away. By doing so, the assets held in their estate will receive a step-up in basis at their passing using a date of death valuation. This effectively eliminates any tax burden if the heirs were to sell those assets immediately after they inherit them. Community, separate, joint tenancy and irrevocable trust property can all be treated differently for step-up purposes, so asset titling can be a critical choice.
As previously noted, when determining whether to defer capital gains or to pay the tax now, it is necessary to consider where capital gains rates currently stand and if they might increase in the future. For instance, if an individual were to defer their capital gain through the use of a 1031 exchange to pay capital gains 10 years in the future, the capital gains tax rates may have increased from current levels to 30-35%, resulting in a more significant tax burden than if the individual had paid the capital gain immediately.
WESCAP Group has created several models that take into account current capital gains tax rates, potential future tax rates and appreciation, to assist in making an informed decision about deferring or paying capital gains.
Please contact WESCAP Group for more information.