I hear it all the time: “It’s only capital gains tax.” People often say that until they actually look at their tax returns when the impact on the bottom line hits.
It is often overlooked that taxes are just about every person’s biggest expense. Income taxes are just one of a large list of taxes everybody pays. But unlike most taxes, you can do some real planning and avoid, reduce or delay some of your income tax liability. Failing to do tax planning can dramatically affect your real bottom line number and net worth.
Q4 2019 hedge fund letters, conferences and more
There has been much talk in recent years about disruption and trying to pick companies that will disrupt their industries. The debate continued at the Morningstar Investment Conference as Bill Nygren of Oakmark Funds faced off with Morgan Stanley's Dennis Lynch. Q2 2021 hedge fund letters, conferences and more Persistence Morningstar's Katie Reichart moderated the Read More
After all, it is not what you make, but what you keep, and that is the biggest truism in financial planning.
Capital gains tax
What people fail to see is how a capital gains event or events can affect the big picture. First, capital gains sit on the bottom of the income tax stack. Your ordinary income sits above and can be driven into higher tax bracket because of the capital gains tax.
Let’s do some back of the napkin numbers to illustrate this. So assume you have $150,000 in ordinary income from your job, plus another $150,000 in capital gains. In that scenario you are paying 24% on most of that ordinary income, and 22% on a small sliver. Without the capital gain, you are paying 10% on a small sliver, 12% on about a third of of it, and 22% on roughly half of it.
On top of that, if you live in a high tax state like New York, Illinois or California, you are paying the full state income tax rate on the capital gain, which can be as high as 13%. And you can no longer deduct that against your federal taxes after you reach $10,000 in state taxes, which is less than just property taxes for many people.
So, should you not sell that real estate, stock, or business asset just because of the taxes? Maybe, but if you think it has reached its full value, or you need the cash, or a myriad of other reasons, think about doing some planning to mitigate the taxes around the sale.
How do you mitigate the capital gains tax? It depends, and deferring or eliminate capital gains tax on the sale of an asset requires advance planning, typically before the sale, and definitely before year’s end. However, there is one tax mitigating option that might still available even if you missed the year-end cutoff.
The Tax Cuts and Job Act of 2017 created a new strategy, the Qualified Opportunity Zone (QOZ). Designed to encourage meaningful investment in economically challenged areas of the country, the recently finalized regulations allow you to invest the gains from the sale of an investment and defer the taxes until 2026, among a host of additional tax benefits. Unlike some other tax strategies, since you only have to invest the gain, the principal or cost basis of your prior investment is freed up for other uses. You just have to make the investment into the QOZ within 6 months of incurring the capital gains, short or long term. Yes, that right, you get to do it after the fact.
Understand that making a QOZ investment has a lot of moving parts and there is a lot more to it than I am covering here. (Please consult a tax advisor.) For starters, the QOZ investment has to be profitable for the strategy to be effective. But all is potentially not lost if you have substantiable tax liability from the sale of an asset and you failed to plan before the transaction, and you missed the ability to use strategies that needed to be completed by year’s end to work. It still may be possible to reduce your 2019 tax bill.
Please note that there are special rules & risks associated with alternative investments & not every investor will be eligible or suitable to invest in alternative investments. Many alternative investments place limitations on who may purchase them based on a person's income & assets & some may only be available to accredited investors. Alternative Investments often include a high degree of risk.