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Higher capital-gains tax rates aren't a certainty for next year—Republicans and Democrats are still at odds over tax policy. But just to be on the safe side, you probably should start planning what to do if rates do go up. Waiting could prove costly.
An obvious way to lessen the burden of any higher rate next year is to sell appreciated assets this year and take advantage of the current 15% rate. But figuring out whether accelerating a sale will benefit you can take some time, "and if you're thinking about selling assets that are not liquid, like real estate, you'll have a long lead time and should put things in motion now," says Bill Fleming, managing director at PriceWaterhouseCoopers.
Not only are the 2003 tax cuts enacted under President George W. Bush set to expire at the end of 2012, allowing the current 15% rate to jump to 20%, but also, as a crowning blow to affluent taxpayers, a new, 3.8% Medicare tax on investment income will go into effect in 2013 under President Obama's health-care act.
Combined, these measures would mean a 59% increase in the long-term capital-gains rate in 2013, to 23.8%.
It clearly complicates planning that neither of these tax hikes is a certainty. The fate of capital-gains rates depends largely on the outcome of the November presidential and congressional elections. Republicans want to lower capital-gains taxes or keep them as is, while President Obama and most Democrats back the 23.8% capital-gains rate, among other tax increases.
If Republicans take the presidency and a majority in Congress, it's likely the Bush tax cuts will be extended. And while it would be difficult to repeal the 3.8% Medicare tax before 2013, that levy may be doomed soon after it goes into effect, says Clint Stretch, managing principal at Deloitte Tax LLP in Washington.
Unfortunately, high-net-worth investors can't sit back and watch how the drama unfolds. The unavoidable truth is that planning takes time.
Here's what savvy tax planners are recommending:
Put the Pedal to the Metal
If you have been planning to sell an appreciated asset sometime soon, regardless of tax rates, it probably makes sense to speed up the process to complete the transaction this year, says Julie-Anne Lewis, managing director of Washington Wealth Management in Middleburg, Va. "The same goes for incentive stock options—capital gains are calculated on the difference between the grant price and the strike price," she says.
The math is simple, Lewis says: If you have a $1,000 gain, would you rather sell it and pay $150 in taxes this year or take the chance that the capital-gains tax rate rises to 23.8% and pay $238?
Stocks and other securities are easy to sell, so you can wait until the end of the year if you believe you can squeeze out more gain before cashing in your shares. But with illiquid assets, such as a small business or a second home, it can take some time to find a buyer and hammer out a deal.
One way to lure buyers in a challenging market, whether you're trying to unload a small business or a second home, is to offer financing, in which the buyer makes payments in installments over a specified number of years.
Under a basic arrangement, the seller realizes gains over the years of the installment agreement. The problem is that if taxes go up, sellers would end up paying more on the gains than if the sale had been paid off in full this year.
"To avoid this, you can do the installment but report the entire gain in the year of sale," says Stephen Kirkland, a tax advisor at Kirkland, Thomas, Watson & Dyches in Columbia, S.C. "If you do that, you generally want to get enough of a down payment from the buyer to cover the tax bill."
If you own a business classified as a C corporation, you could sell appreciated assets such as an investment property to the business, but be careful if you ever want to the buy the asset back, says Jeffery Hill, a tax advisor and partner at Margolis, Phipps & Wright in Houston.
"If your corporation sells it back to you, it will have to pay corporate-level tax, which is up to 35% on any gains that have accrued. If you want to get that cash out of the corporation eventually, it will be subject to dividend taxes," Hill says. "That's a double tax, and I'm not sure you accomplish your goal of just paying the 15% tax."
Keep in mind that gains on precious metals and collectibles– this includes artwork—are taxed at 28%. The rate isn't expected to change next year, so for Fabergé eggs, Picassos and gold coins, not much tax planning is required.
Sell the Asset, Buy It Back
If you have big gains built up in an investment you're not ready to part with, consider selling it this year, paying 15% on the gain, then buying it back immediately. When you sell sometime in the future, your gain will be based on a new, higher cost basis, which is the value of the investment at the time you buy it.
Sounds simple, but benefits aren't guaranteed, so be sure to do the math. Depending on your assumed rate of return, and how long you expect to hold your investment, you may end up with more in your pocket if you defer taxes until a later date, even if the tax rate you'll pay is higher, says Rande Spiegelman, vice president of financial planning at the Charles Schwab Center for Financial Research.
Generally, you'll benefit from selling now and reinvesting the after-tax amount if you have a fairly short time horizon, of up to six or seven years. Otherwise, you'll fare better by not tampering with your cost basis now.
Say you have $100,000 in a stock, and for simplicity's sake, your cost basis is zero and all of it is a long-term capital gain. Assume you sell it this year and pay a 15% capital-gains tax, then reinvest the remaining $85,000 to establish $85,000 as your new cost basis. If you earn 8% annually, and sell after five years and the capital-gains tax rate is 23.8%, you'll pocket $115,398, compared with $111,962 if you hadn't locked in a higher cost basis this year.
But by the eighth year, the math starts favoring the do-nothing strategy. If you sell and reinvest this year, you'd have $140,040 by the eighth year. If you simply waited until year eight, you'd have $141,040.
The longer you hold the investment, the more you benefit from deferring your tax bill. By the 10th year, the difference is $160,063 versus $164,509, and by year 20 the gap widens: $322,199 versus $355,162.
Also keep in mind that if you sell and buy back an investment, you must hold it for more than a year before selling again or you will be subject to short-term capital gains rates. Short term rates match the rates on ordinary income, such as salaries, and ordinary rates are also poised to go up next year from a top rate of 35% to 39.6%, plus the 3.8% Medicare tax on top of that for a total 43.4%.
If you do pursue this strategy despite the caveats, you may buy back your investment immediately, so you're unlikely to miss out on any significant gains. The rules are different if you incur losses; then you must wait for 30 days before repurchasing the investment under the so-called wash-sale rule.
For a quick sale-and-buyback of appreciated property such as a ski chalet, "there are no rules against selling to a friend or family member, then buying it back," Hill says. "But you can't have any strings attached—if I sell to you and you change your mind and want to keep it, there's nothing I can do about it."
But be sure to consider transaction costs —unless your gains are substantial, they may negate any tax advantages of a quick sale, Hill says.
Factor In Passive Losses
If you have a rental property you have been considering selling—perhaps a beach house you rent out for part of the year—the size of your unused passive losses should factor into the timing of your sale, says tax advisor Kirkland.
Passive losses are incurred when routine expenses, such as for utilities and maintenance, exceed rental income. As long as you own the property, the passive losses can be used only to offset passive income. But once the property is sold, any unused passive losses—known as "suspended" losses—can be used to offset wages or other income.
Assuming tax rates will be higher in future years, if you have no or minimal passive losses, from a tax perspective it makes sense to unload the property this year.
If you have sizable suspended passive losses, you have to run the numbers to determine whether it makes sense to sell in a higher-rate environment, pay a higher tax bill on the gain, but get the benefit of being able to offset other income with the passive losses, Kirkland says.
Tally Up State Taxes
Before you jump to lock in gains this year, don't forget to consider state capital-gains taxes. Forty-four states impose such taxes, and many are significant. "You may figure it's better to pay the 15% federal rate this year, but in New York City you're going to pay another 13.5% on gains, and in California you'll pay more than 10%," says Jonathan Blattmachr, principal at Eagle River Advisors in New York.
Make the Most of Losses
Careful planning for realizing investment losses can help minimize capital-gains taxes. Investment losses can be used to offset investment gains, and if you have more losses than gains you can use up to $3,000 a year to offset other income. Excess losses are carried into future years.
You may be tempted to time the sale of losers and winners until next year, when rates are higher. The higher the rates, the more valuable the offset.
Depending on the investment and the timing, this may make sense. But don't do this without considering the bigger investment picture, says Tim Steffen, director of financial planning at Robert W. Baird & Co. If waiting means your investment will lose more, cut your losses sooner rather than later, he says.
"A modest loss that offsets 15% now is better than a much bigger loss that offsets 20% later," Steffen says. "If you only look at the tax side, you can get into trouble."
If you're sitting on some big carryover losses from previous years, unfortunately you can't pick which year you want to use them, Kirkland says. If you realize gains this year, you must use the carryover losses rather than wait until rates may be higher.
There are, after all, limits to Uncle Sam's generosity.
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