When you make a profit from the sale of an asset — such as a business, piece of land, or shares of stock — you may be subject to capital gains taxes. Capital gains can be taxed at the same rate as ordinary income, which can be as high as 37% or as low as 0%, depending on your tax bracket. However, there are strategies that investors use to offset capital gains tax liability.
Here are some strategies that can help lower your capital gains tax burden.
Wait Longer Than a Year Before Selling
When an asset is held longer than a year before it’s sold, it qualifies for long-term status, thus lowering your capital gains tax rate. Long-term capital gains are taxed at 0%, 15%, or 20% while short-term capital gains are taxed at ordinary income rates, depending on your tax bracket. Because long-term capital gains are generally taxed at a more favorable rate, it’s recommended that you hold assets for at least a year before selling.
Tax Loss Harvesting
You can offset capital gains with capital losses experienced during the tax year or by carrying it over from a previous year with a strategy known as tax loss harvesting. Using tax loss harvesting, investors can lower tax consequences by selling securities at a loss. If losses exceed gains, taxpayers can use up to $3,000 a year to offset ordinary income on income taxes.
Using an example, let’s say you made $10,000 on Asset A but Asset B is down by $2,000. By selling Asset B at a loss, you can offset gains from Asset A and owe taxes on $8,000 instead of the full $10,000. If your loss from B was more than the gain from A, you can offset your entire gain and deduct $3,000 from your taxable income.
Sell When Income Is Lower
If you or your spouse recently quit or lost a job, or if you’re about to retire, selling during a low-income year could put you in a lower tax bracket. By entering in a lower tax bracket, you can lower the rate at which your capital gains are taxed.
Reduce Taxable Income
Reducing your taxable income is a great way to potentially minimize your short-term capital gains tax rate, considering it’s based on your income. You can take advantage of deductions and credits before filing your tax returns or by making contributions to a traditional IRA or 401(k). There are other ways to reduce your taxable income such as investing in municipal bonds. The interest from most municipal bonds is exempt from federal and some state income taxes. For more credits and deductions to lower your taxable income, the IRS provides a database for credits and deductions for individuals.
Defer Capital Gains With a 1031 Exchange
A 1031 exchange allows investors to sell an investment property and roll the proceeds from its sale into a like-kind replacement property. By doing a 1031 exchange, investors defer their capital gains tax liability indefinitely so long as they keep reinvesting capital back into the property. Property can be swapped until death and the beneficiaries can receive a one-time step-up in basis, potentially eliminating the capital gains tax liability. The rules for a successful 1031 exchange are complicated and follow a strict timeline. This strategy also requires help from a qualified intermediary.
It’s not only the wealthy who can offset capital gains taxes. By knowing the right strategy for you, most taxpayers have the potential to save. Consult with a tax professional to make sure you qualify for certain deductions.