Are you wondering how to avoid the capital gains tax?
First, let’s clarify exactly what the term capital gains tax means. A capital gains tax is the fee you’re responsible for paying to the IRS after making a profit from selling an asset. It applies to stocks, bonds, securities, real estate, cars, boats, gold, furnishings, and other assets.
A capital gain is assessed based on what you pay for an asset versus the amount you get when you sell it. Additionally, there are two ways capital gains are taxed, based on how long you hold an asset.
If you hold an asset for a year before selling it, you’re in the sweet spot to qualify for a favorable long term capital gains rate. However, if you sell before a year, you’ll be taxed at a higher rate for a short term capital gain.
The good news is that there are plenty of tips for staying tax-free to get the perks of a capital gain without the penalties.
1. Invest in a Tax-Deferred Savings Plan
A capital gains tax liability isn’t triggered when you buy or sell securities within tax-deferred retirement plans. This includes Roth IRAs, traditional IRAs, SDIRAS, and 401(k) plans.
Your capital gains won’t be taxed until you begin withdrawing funds from your account. This strategy isn’t just delaying pain until that day. Capital gains are taxed at your ordinary income rate. so people who slide into lower tax brackets after retirement can benefit.
What’s more, any Roth IRA and 401(k) funds specifically are immune to capital gains taxes under some conditions.
2. 1031 Exchange
Are you planning to be a repeat investor? Some perpetual property investors never get stuck holding the bag with capital gains because they take advantage of the 1031 exchange loophole.
Section 1031 of the U.S. Internal Revenue Code allows you to avoid paying gains taxes after selling an investment as long as you reinvest the proceeds from the sale within a certain window of time. The stipulation is that you must reinvest in a similar property that’s of greater or equal value to the one you sold. However, this strategy is a great way to raise capital for real estate.
3. The Primary Residence Exclusion
What exactly is the primary residence exclusion? This little-known IRS rule allows people who meet specific criteria to exclude $250,000 (single filers) to $500,000 (married filing jointly) in capital gains tax after making a profit from selling a home. Here’s what’s required:
- The home you sold was your true primary residence.
- You’ve owned and used your home as your main residence for at least two out of the five years prior to its sale date.
- You haven’t already used the primary residence exclusion for another home during the two-year period before the sale of your home.
You must report the sale of your home even if your gain is considered excludable. The IRS also provides some exceptions for the five-year usage test. Homeowners on extended duty in the military or intelligence community may be eligible to have the period bumped up to 10 years.
4. Donate to Charity
One of the smartest ways to offset capital gains if you cannot avoid selling assets when your income places you in a high tax bracket is to utilize tax deductions for charitable donations. An accountant may be able to help you donate the right amount to slide into a lower bracket to avoid a larger-than-necessary tax bill. This strategy applies if you’re itemizing your deductions.
5. Offset Gains With Losses
A capital loss is any loss on the sale of a capital asset. This includes stocks, bonds, and investment real estate. Capital losses are actually divided into long-term and short-term losses using the same calendar used for measuring long-term and short-term gains.
In fact, short-term and long-term losses are actually first deducted against short-term gains and long-term gains. While tax laws are always changing, you can generally expect to be able to deduct an overall net capital loss for the year against salary, interest income, and other forms of income. Excess net capital losses can also be carried over to future tax years.
6. Invest in Long-Term Stocks
This next tip shouldn’t necessarily be done without the help of a tax professional. One slightly intricate way to potentially defer capital gains tax until 2026 is by investing unrealized capital gains within 180 days of a stock sale into something called an Opportunity Fund.
In addition, some investors take advantage of small business stocks to have up to $10 million in capital gains excluded from income.
The trick is understanding how to invest during inflation to counteract any losses.
8. Figure Out Your Cost Basis
You can keep more of your capital gains by subtracting the cost basis from your sale price. How you calculate cost basis can impact your capital gain rate. Many people find that adjusting the original purchase price to account for commissions and fees can reduce taxable gains.
9. Gift to Someone or Move Somewhere With a Lower Tax Bracket
Finally, some creative strategies are available if you’re stuck with paying capital gains based on the way your sale price intersects with your income bracket. For example, consider gifting the appreciated asset to a family member instead of selling it.
The IRS currently allows taxpayers to gift a person between $16,000 (single filer) and $32,000 (couple filing jointly) without needing to file a gift tax return. When you gift the asset to another person, the gains are taxed based on that person’s income instead of your income. Just be cautious about using this strategy to gift assets to children or students under the age of 24 because dependents are taxed at the same rates as their parents.
Final Thoughts on How to Avoid Capital Gains Tax
The key to understanding capital gains is knowing that the tax code rewards investors in it for the long game. The simplest way to avoid capital gains tax when selling an investment asset is to get past the one-year threshold for ownership before selling.
Capital gains are taxed based on your ordinary income rate, so reducing income through losses, donations, or other means is the other strong alternative for avoiding a huge tax hit.