Avoiding capital gains tax is the goal of every investor, and reinvestments are an effective way to do exactly that. As I’ve discussed in various articles such as Should I take my dividends in cash or reinvest them?, Reinvesting dividends can help you avoid capital gains tax. However, many investors, taxpayers and advisors don’t know how it works when it comes to reinvesting stocks in an IRA.
Chances are that you’ve heard about the possibility of paying tax on your stock gains. If you’re not careful, you can end up paying more taxes than you have to. While the US is one of the most tax-friendly countries in terms of property ownership, there is one aspect where it can be quite tricky – capital gains taxation. Keep reading this article to learn How to Avoid Capital Gains Tax on Stocks.
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What are capital gains taxes?
Capital gains as they pertain to stocks occur when an investor sells shares of an individual stock, a stock mutual fund, or a stock ETF for more than they originally paid for the investment. For example, if you buy 100 shares of a stock at $25 per share and later sell them for $40 per share you will have realized a capital gain of $15 per share or $1,500 total on the 100 shares.
ETFs and mutual funds can also incur capital gains realized from the sales of the stocks held within the mutual fund or ETF.
The Internal Revenue Service defines capital gains as either short-term or long-term:
- Short-term capital gains: Capital gains on stocks that are held for less than one year are taxed at your ordinary income tax rate. There is no different treatment for tax purposes.
- Long-term capital gains: If the shares are held for at least one year, the capital gain is considered to be long-term. This means the gain is taxed at the long-term capital gains tax rate, which is lower than the ordinary income tax rates for many investors.
Work your tax bracket
While long-term capital gains are taxed at a lower rate, realizing these capital gains can push you into a higher overall tax bracket as the capital gains will count as a part of your AGI. If you are close to the upper end of your regular income tax bracket, it might behoove you to defer selling stocks until a later time or to consider bunching some deductions into the current year. This would keep those earnings from being taxed at a higher rate.
Use tax-loss harvesting
Tax-loss harvesting is an effective tool whereby an investor intentionally sells stocks, mutual funds, ETFs, or other securities held in a taxable investment account at a loss. Tax losses can be used in several ways including to offset the impact of capital gains from the sale of other stocks.
Capital losses are used to offset capital gains as follows:
- Long-term losses offset long-term gains
- Short-term losses offset short-term gains
Any excess losses of either type are used to offset additional capital gains first. Then, to the extent that your losses exceed your gains for the year, up to $3,000 may be used to offset other taxable income. Additional losses can be carried over to use in subsequent tax years.
A key point is to ensure that you avoid a wash sale when using tax-loss harvesting. The wash sale rule says an investor cannot purchase shares of an identical or substantially identical security 30 days before or within 30 days after selling a stock or other security for a loss. Essentially this creates a 61-day window around the date of the sale.
For example, if you plan to sell shares of IBM stock at a loss, you must refrain from buying shares of IBM during that 61-day span. Similarly, if you sell shares of the Vanguard S&P 500 ETF at a loss and then buy another ETF that tracks the same index, that might be considered “substantially identical.”
Violating the wash sale rule would eliminate your ability to use the tax loss against capital gains or other income for that year. This rule also extends to purchases in accounts other than your taxable account, such as an IRA. If you have questions about what constitutes a wash sale, it’s best to consult your financial advisor.
Many of the top robo-advisors like Wealthfront automate tax-loss harvesting, making it simple even for novice investors.
Donate stocks to charity
Planning to make a big donation to a qualifying charity? Instead of selling the appreciated stock, paying the capital gains tax, and then donating the cash proceeds, just donate the stock directly. That avoids the capital gains tax completely. Plus, it generates for you a bigger tax deduction for the full market value of donated shares held more than one year, and it results in a larger donation.
With donations that put you over the yearly standard deduction amount, the stock donation also reduces your overall taxable income. You could donate the shares to a donor-advised fund if you’re uncertain about your philanthropic goals for all the stock. If you’re fortunate enough to be wealthy, consider a charitable remainder trust or private foundation.
Buy and hold qualified small business stocks
Private company shares held for at least five years that are considered qualified small-business stock (QSB) may be eligible for an income exclusion of up to $10 million or 10 times their cost basis. This is separate from the approach of rolling over your capital gains by reinvesting them within 60 days of sale in another startup. For the stock to qualify, the company must not have gross assets valued at over $50 million when it issued you the shares. For more details on both the rollover deferral and the 100% gain exclusion strategies for QSB sales, see a related article on myStockOptions.com, a website featuring expertise on tax and financial planning for all types of stock compensation.
Reinvest in an Opportunity Fund
An opportunity zone is an economically distressed area that offers preferential tax treatment to investors under the Opportunity Act. This was a part of the Tax Cuts and Jobs Act passed in late 2017. Investors who take their capital gains and reinvest them into real estate or businesses located in an opportunity zone can defer or reduce the taxes on these reinvested capital gains. The IRS allows the deferral of these gains through December 31, 2026, unless the investment in the opportunity zone is sold before that date.
Hold onto it until you die
This might sound morbid, but if you hold your stocks until your death, you will never have to pay any capital gains taxes during your lifetime. In some cases, your heirs may also be exempt from capital gains taxes due to the ability to claim a step-up in the cost basis of inherited stock.
The cost basis is the cost of the investment, including any commissions or transaction fees incurred. A step-up in basis means adjusting the cost basis to the current value of the investment as of the owner’s date of death. For investments that have appreciated in value, this can eliminate some or all of the capital gains taxes that would have been incurred based on the investment’s original cost basis. For highly appreciated stocks, this can eliminate capital gains should your heirs decide to sell the stocks, potentially saving them a lot in taxes.
Use tax-advantaged retirement accounts
If stocks are held in a tax-advantaged retirement account like an IRA, any capital gains from the sale of stocks in the account will not be subject to capital gains taxes in the year the capital gains are realized.
In the case of a traditional IRA account, the gains will simply go into the overall account balance that won’t be subject to taxes until withdrawal in retirement. In the case of a Roth IRA, the capital gains will be part of the account balance that can be withdrawn tax-free as long as certain conditions are met. This tax-free growth is one reason many people opt for a Roth IRA.
Qualified Opportunity Zones
The Tax Cuts and Jobs Act created “Opportunity Zones” to encourage investment in low-income distressed communities that need funding and development. This is the newest way to defer and potentially pay no capital gains tax. By investing unrealized capital gains within 180 days of a stock sale into an Opportunity Fund (the investment vehicle for Opportunity Zones) and holding it for at least 10 years, you have no capital gains on the profit from the fund investment.
For realized but untaxed capital gains (short- or long-term) from the stock sale:
- The tax on those capital gains is deferred until the end of 2026 or earlier should you sell the investment.
- For capital gains placed in Opportunity Funds for at least 5 years until the end of 2026, your basis on the original stock investment increases by 10%. The basis increase goes to 15% if invested at least 7 years until that date (this means you must make the investment by December 31, 2019 to potentially get the 15% basis bump).
The new tax incentive is complex and controversial. It faces potential legislative changes. Unresolved issues also remain on some aspects, as shown by FAQs and ongoing guidance from the IRS.
Conclusion
Capital gains tax is one of the most misunderstood taxes. I’ve read things like, “capital gains should only apply to stock market investments” or “capital gains should be exempted on property that you live in.” These are just myths that people don’t understand the tax system.