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Capital Gains Planning Strategies

Capital gains tax rates are at historic lows, but they are in the political crosshairs. It’s a good idea to take advantage of planning strategies now.

Capital gains contribute to a taxpayer’s adjusted gross income. An investor realizes capital gains when he sells investments for more than he paid for them; capital losses are the opposite. All of an investor’s capital gains and capital losses are first combined to create a net capital gain or loss. A net capital loss can offset up to $3,000 of other income, with the remainder carrying forward for use in future tax years. Like other income, a net capital gain is subject to tax, though the rate can be different from that which applies to ordinary income.

Currently, while short-term capital gains are taxed at an investor’s ordinary income tax rate (as much as 35 percent), long-term capital gains — those realized from assets held for one year or more — are generally taxed at 15 percent; for investors in the 10 percent and 15 percent tax brackets, the tax on long-term capital gains is zero.

These rates originated in the Jobs and Growth Tax Relief Reconciliation Act of 2003, and President George W. Bush later extended them when he signed the Tax Increase Prevention and Reconciliation Act, in 2006. They were extended again last year as part of the very public legislative struggle that eventually retained many of the Bush-era tax cuts.

As the current political atmosphere might suggest, it is difficult to predict what will happen to the tax rates in the future. However, it is likely that they will go up. The current rates are set to expire in 2012 if no new legislation prevents it. Long-term capital gains would return to a tax rate of 20 percent, or 10 percent for taxpayers in the 15 percent tax bracket. Even if current law is not allowed to expire, the smart money will bet on congressional action resulting in higher rates.

Regardless of whether the rates change next year, many strategies can defer or reduce capital gains tax. Depending on your situation and your aims, one or more of these courses may help you minimize your gains’ tax impact.

The most obvious way to take advantage of the current low rates is an outright sale of the security, triggering the tax now.

Alternatively, if you have children over 17 years old whose income is relatively low, you might consider giving appreciated securities to them as a gift. The children’s lower tax bracket would mean they could pay little or no tax on the capital gains they would realize when they sold the securities. Thus, a holding worth $5,000 with a $1,000 cost basis would, when sold, yield $5,000 directly to your child. If you were to sell the security yourself to give the same child a gift in cash, you would lose $600 of your $4,000 gain to tax, either yielding a smaller gift or leaving you to make up the difference. The benefits of this strategy could vary if the rates change, but this approach will generally work whenever the parents’ tax rate on capital gains is higher than the children’s rate.

A Charitable Solution

For those with philanthropic intent, donating appreciated securities directly to a charity is also a sound strategy. Since such organizations are tax-exempt, the gains would be realized without tax, making your gift more effective for the charity and for you.

For example, assume you own $1 million of a stock with a long-term hold period and a cost basis of $100,000. If you were to sell the stock and give the cash proceeds to charity, you would get a $1 million charitable deduction, but you would also realize a $900,000 capital gain, resulting in $135,000 of tax. If you were to give the $1 million of stock directly to the charity, you would end up with the same $1 million charitable deduction, but realize no taxable gain.

One drawback is that gifts of cash to qualified charities are deductible in the current year up to a limit of 50 percent of your adjusted gross income, while gifts of appreciated stock are limited to 30 percent. In either case, unused charitable deductions can carry forward up to five years.

If you suspect an asset’s value may have peaked and prompt liquidation is the goal, or if you wish to combine deferring your own capital gains tax with an ultimate gift to a charity, a Charitable Remainder Unitrust (CRUT) may make the most sense. In this trust, established for a set amount of time or for the remainder of your life, you transfer an appreciated asset directly into the trust.

The terms of the trust provide a yearly payment to the grantor: for example, 5 percent of the previous year’s value on Dec. 31. At the end of the trust term, the remainder passes to charity. Upon contribution of an asset to a CRUT, the trust can then sell the asset, realizing the capital gain. As the trust is a tax-exempt entity, the gain is not taxed, but rather is retained in the trust. When annual distributions take place, a portion of the gain is passed out with the distribution.

The character of the income out of the trust proceeds from worst to best taxation: The earliest distributions are drawn from income taxed at the highest applicable rate for as long as income of that character remains, before moving on to the next sort of income. As you receive the distributions, you will have to pay ordinary income or capital gains tax, but only on as much of the income as you receive.

Besides spreading the tax burden over time, the CRUT strategy also allows you to diversify your position quickly, by selling a concentrated position immediately after contributing it to the CRUT, without worrying about a large capital gains tax up front. Further, the cash distributions are based on a percentage of the trust’s value, and can thus vary from payment to payment. Depending on the performance of the assets in the trust, you may potentially pay less tax than you would have if you’d sold the asset outright.

An example helps to illustrate the strategy. Assume the same $1 million stock with a $100,000 cost basis. You contribute the stock to a CRUT with a 10 percent annual payout, and the CRUT immediately sells the stock. The $900,000 of realized capital gain is retained in the trust, and is not taxed that year. The trustee of the CRUT reinvests the $1 million proceeds in a diversified portfolio. In the first year, the annuity payout is 10 percent of the $1 million value from the prior year, or $100,000. This distribution to the grantor is taxable as $100,000 of long-term capital gains. The trust now retains $800,000 of taxable long-term gains embedded in it.

The next year, the portfolio appreciates by 12 percent, and is worth $1,008,000. Next year’s payout to the grantor will be $100,800. This process continues until the trust terminates.

At the end of the trust’s term, the remainder will go to the charitable beneficiary you’ve named. Since this will be a tax-exempt organization, it will pay no tax. This means that, in some cases, the capital gains tax won’t only be deferred, but will actually be less than it would have been without the trust.

Exchange Funds

Besides using your appreciated securities for charitable purposes, you can invest them in other ways to defer and minimize the taxes on your capital gains. If you have a large, undiversified position in a stock with a low cost basis, an exchange fund could be a logical solution.

The idea behind an exchange fund is to protect investors against concentrated stock positions, which are riskier than a diversified portfolio. You invest some portion of your undiversified stock in the exchange fund, and other investors in similar situations do the same. These stocks, pooled together, create a diversified portfolio that is less volatile than any of its individual component stocks.

Theoretically, the component stocks are diverse enough that the fund will more or less mimic the general market performance, tracking the S&P 500 much as an index fund does. In reality, this tracking is never perfect, so if your stock holdings are very large, you might also consider investing portions of the stock in different exchange funds, for added diversification.

Beyond allowing diversification without having to sell stock (and thus having to pay capital gains tax before reinvesting), exchange funds have another benefit. When you decide to leave — usually after required participation of at least seven years — you will not receive a cash distribution or your original stock. Instead, you’ll receive a basket of diversified stocks from the fund, prorated to reflect the fair market value of your interest. The cost basis of these new stocks is equal to the original cost basis of the stock you contributed, divided pro rata among the stocks received, leaving you free to decide to hold or sell the newly diversified
stocks.

An example is useful here, as well. Again, assume the same stock. You contribute the $1 million position with a $100,000 cost basis to an exchange fund. In return, you receive an interest in the partnership worth $1 million. That partnership is invested in hundreds of stocks, and its performance closely tracks the S&P 500 index. Assume the market appreciates at an average annual rate of 8 percent for seven years. The partnership interest would then be worth $1,713,824. At this point, you redeem your interest, and the partnership gives you 10 stocks, each worth about $171,000. These 10 stocks each have a cost basis of $10,000.

Regardless of the approach you take, it’s wise to plan now, while capital gains tax rates are low. Chances are growing that they won’t stay that way.

Vice President Eric Meeermann, who is based in our Stamford, Connecticut office, contributed several chapters to our firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 11, “Social Security And Medicare;” Chapter 18, “Philanthropy;” and Chapter 19, “A Second Act: Starting A New Venture.”

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