Let’s say you own stock that may generate a big capital gain when you sell it. It could be shares in Apple or Amazon that you purchased a long time ago, founder’s stock in a startup that turned into a hot IPO company, or shares from employee stock option exercises or restricted stock vesting that have appreciated substantially. While most securities held over one year qualify for the favorable rate on long-term capital gains, the total tax can still be significant.
The complex federal tax code provides a few ways, depending on your income, personal financial goals, and even your health, to defer or pay no capital gains tax. If you follow the rules and consult tax experts when needed for the more sophisticated techniques, these tax-planning opportunities below are not tax dodges or loopholes that will get you in trouble with the IRS. Most are considered tax expenditures (i.e. what we tax geeks and the US Treasury Department refer to as tax-code provisions created to encourage certain activities or benefit certain categories of taxpayers).
1. The 10%–15% Tax Bracket
For people in the 10% or 12% income tax bracket, the long-term capital gains rate is 0%. Under the Tax Cuts & Job Act, which took effect in 2018, eligibility for the 0% capital gains rate is not a perfect match with the income ceiling for 12% income tax rate. The income thresholds for the 0% are indexed for inflation:
- in 2019, $39,375 (single filers) and $78,750 (joint filers)
- in 2020 (estimated), $40,000 (single filers) and $80,000 (joint filers)
Before you believe you quality for this special 0% capital gains rates, or think you can shuffle your stock to someone else in a lower tax bracket who can sell to get the 0% rate, you want to be sure you don’t trip over the tax rules. For example, the net proceeds from your stock sale count against the income limit. Should you decide this is a good year to convert a traditional IRA to a Roth IRA, that income counts, too. The “kiddie” tax is triggered should the gifted stock be sold by a child under the age of 19 (for full-time students, under the age of 24).
2. Using Tax Losses
Capital losses of any size can be used to offset capital gains on your tax return to determine your net gain or loss for tax purposes. This could result in no capital gains at all to tax. Called tax-loss harvesting, this is a popular strategy. While only $3,000 of net capital losses can be deducted in any one year against ordinary income on your tax return, the remaining balance can be carried over to future years indefinitely. When you follow this strategy in selling losers, you want to be careful to avoid the rules about “wash sales” should you plan to soon repurchase the same stock. (See my Forbes.com blog commentary on this: Year-End Stock Sale To Harvest Capital Losses: Beware Wash Sales!)
3. Stock Donations
Planning to make a big donation to a qualifying charity? Instead of selling the appreciated stock, paying the capital gains tax, and then donating the cash proceeds, just donate the stock directly. That avoids the capital gains tax completely. Plus, it generates for you a bigger tax deduction for the full market value of donated shares held more than one year, and it results in a larger donation.
With donations that put you over the yearly standard deduction amount, the stock donation also reduces your overall taxable income. You could donate the shares to a donor-advised fund if you’re uncertain about your philanthropic goals for all the stock. If you’re fortunate enough to be wealthy, consider a charitable remainder trust or private foundation.
4. Qualified Small Business Stock
Private company shares held for at least five years that are considered qualified small-business stock (QSB) may be eligible for an income exclusion of up to $10 million or 10 times their cost basis. This is separate from the approach of rolling over your capital gains by reinvesting them within 60 days of sale in another startup. For the stock to qualify, the company must not have gross assets valued at over $50 million when it issued you the shares. For more details on both the rollover deferral and the 100% gain exclusion strategies for QSB sales, see a related article on myStockOptions.com, a website featuring expertise on tax and financial planning for all types of stock compensation.
5. Qualified Opportunity Zones
The Tax Cuts and Jobs Act created “Opportunity Zones” to encourage investment in low-income distressed communities that need funding and development. This is the newest way to defer and potentially pay no capital gains tax. By investing unrealized capital gains within 180 days of a stock sale into an Opportunity Fund (the investment vehicle for Opportunity Zones) and holding it for at least 10 years, you have no capital gains on the profit from the fund investment.
For realized but untaxed capital gains (short- or long-term) from the stock sale:
- The tax on those capital gains is deferred until the end of 2026 or earlier should you sell the investment.
- For capital gains placed in Opportunity Funds for at least 5 years until the end of 2026, your basis on the original stock investment increases by 10%. The basis increase goes to 15% if invested at least 7 years until that date (this means you must make the investment by December 31, 2019 to potentially get the 15% basis bump).
The new tax provision is complex. Unresolved issues remains on some aspects, as shown by FAQs and ongoing guidance from the IRS.
6. Die With Appreciated Stock
The standard calculation for capital gains in your retail brokerage account (not securities in a 401(k), IRA, or other tax-qualified retirement plan) after commissions and fees is:
capital gains = sale proceeds – cost basis (purchase price of stock)
Should you sell the stock during your lifetime, the net proceeds in this equation are your capital gains (or losses). Should you gift the stock, the cost basis carries over to the new owner.
Yet when you die before selling or gifting, this cost basis in most situations is “stepped up” to the fair market value on the date of death. The stock escapes the capital gains tax on the price increase during your lifetime, regardless of the size of your estate. (Any potential capital loss deduction also goes away should the stock price have dropped since purchase.) Thus, no taxable gain is recognized when the inherited shares get sold at no higher than the death-date price.
All the 2020 Democratic presidential candidates seem to be calling for the elimination of this provision. This tax rule, which was not changed when the estate tax income exemption amount increased, is viewed as a tax loophole for super-wealthy people who create sophisticated trusts and estate-planning strategies. However, this tax treatment at death to step up the basis is available for everyone and does eliminate (or reduce) the taxes your heirs and beneficiaries pay.