As you prepare to sell a large asset - such as a business, real estate, or investment portfolio - have you thought about capital gains tax? Many Americans know little or nothing about this type of income tax, but it can have a profound effect on your profit margin. Failure to minimize capital gains tax could cost hundreds, thousands, or even millions of dollars when you try to recoup your investments.
So, what should you know about capital gains? And how can you minimize the tax consequences? Here is a short guide to the complex world of capital asset sales.
What Are Capital Gains Taxes?
A capital gain is simply the profit you reap when you sell an asset that has appreciated (is worth more than you paid for it). This profit is your gain. If you sell an asset for less than what you put into it, you have a loss. However, the calculation for what you paid for the investment isn't always easy.
Consider an example of a commercial building. You have the original purchase price, to which you would add such things as closing costs, some taxes, legal fees, or freight costs related to the initial setup. You would then add major repairs or upgrades made over the years as well as certain costs charged by the city or county. Finally, you subtract depreciation taken as an expense over the years. This evaluation can get very complicated.
What Are Short Term and Long Term Gains?
Capital asset sales are categorized into two types. Assets you have held in hand for less than one year are considered short term gains or losses. Assets held for more than a year are long term gains and losses. Each category calculates its own gains and losses separately before these are combined as a net gain or net loss overall on your income tax form.
One part of the complexity comes from different rules that determine your holding period depending on how you acquired the asset. If you received an asset from your business or inherited it, for instance, the holding period generally includes how long the business held it. But a purchase from other business partners may not include their holding period.
How Are Capital Gains Taxed?
Capital gains are investments, so they often have different tax rates than income earned from your job or business. This can be very confusing, and it may result in paying more tax than you would on other income - or lower tax than you would otherwise. Why? Short term gains or losses are generally treated the same way as your salary for tax purposes. But long term gains or losses are usually taxed at a lower rate - between 0% and 20%. Investments labeled as collectibles (coins, antiques, or your baseball cards, for instance) have their own rules and may be taxed at 28% regardless of your other income.
What is my Long Term Capital Gains Tax Rate?
Long Term Capital Gains tax rates vary depending on your tax bracket. Lower tax brackets currently pay no tax on long term capital gains. The current capital gains tax for those above the lowest tax bracket but below the highest tax bracket the long term capital gains tax rate is 15%. For those with taxable incomes in the highest tax bracket the long-term capital gains tax rate is 20%.
Are There Any Other Taxes Associated With the Sale of My Asset?
The Net Investment Income Tax may be applied to your sales proceeds if your income exceeds certain levels. The NIIT is an additional 3.8% tax that is applied to interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer (within the meaning of section 469).
What Can You Do About the Tax?
Clearly, capital gains taxes can add up quickly when you sell a large asset or several different assets in the same year. To minimize taxes, you would first want to work with an experienced accountant to ensure that you are using the correct basis (investment cost) to reduce the profit on paper. You may also be able to time asset sales to coincide with more favorable tax rates or to harvest certain losses.
There are four main planning strategies to reduce or defer capital gains taxes: 1. if available utilize an installment sale to spread the tax burden over a number of tax years 2. Charitable Remainder Trust 3. Invest the capital gain into an opportunity zone investment 4. Utilize an Asset Exchange Trust.
Installment Sales: If the buyer and seller agree to an installment sale the structured agreement can help to keep you out of the highest tax brackets by spreading the long term capital gain into several years. This can significantly reduce your overall tax consequence; however, it does expose the seller to the ongoing risk that the buyer may not be able to pay in full over future years.
Charitable Remainder Trust: A CRT is an irrevocable trust designed to reduce the taxable income of individuals. The trust is established by first donating assets into the trust and then having it pay the beneficiary for a stated period of time. The remainder is then donated to a designated charity. The rules surrounding CRTs can be quite complex, but their popularity has decreased in recent years due to the current low interest rate environment that affects the payouts to the beneficiary.
Opportunity Zone Investment: Opportunity zone investments have several tax benefits allowed by the government to encourage the development of low growth areas of the country. An opportunity zone investment will enable the investor to defer capital gains for several years and any gains from the opportunity zone investment itself are not taxable if held for over 10 years. This can be quite attractive from a tax savings stand point; however, the viability of the investment is very important and thorough due diligence is required. Additionally, since minimum holding periods are required to receive certain tax benefits the investment is typically illiquid for a number of years.
An Asset Exchange Trust: The Asset Exchange Trust allows sellers to utilize a third party trust structure to accomplish similar results as an installment sale while not having the buyer risks that are inherent in installment sales. The trust also allows for more flexibility in structuring a payment schedule that works best for the seller. The sales proceeds can be invested across multiple asset classes vs an installment sale that is usually only backed by a single business or asset.
At The Asset Exchange, our specialty is working with you to minimize your capital gains tax obligation. Call today to learn about options available to investors and business owners.