Keeping your approach simple has its upsides, but advanced capital gains tax planning can take your tax savings to the next level.
For some people, effectively and consistently implementing basic tax planning concepts such as the ones we discussed in part one of this series is sufficient. However, such straightforward approaches may not fully address every individual taxpayer’s situation. If your circumstances are more complicated, you may get more mileage from specialized capital gains planning options.
Although the methods discussed in this article are not suitable for every investor, one or more may fit your specific financial goals. Because this article is a broad overview of different capital gains planning options, we will not discuss the nuances of each technique in depth. If you think a strategy might be effective for your situation, you should research the technique in more detail. Ideally, you will want to discuss it with a professional who can fully identify the pros and cons of applying the technique in your unique circumstances.
Diversifying Without Selling
When people need cash or want to reduce their exposure to a particular investment, their first instinct is often to sell it. While selling is the most straightforward option, it will create a tax liability if the asset has appreciated. Consider whether there are other ways to achieve your goals. If you just need cash, for example, you might borrow money against an asset rather than selling it.
If you no longer want to own a particular investment, either because it has grown in value enough that you are deviating from your investment plan or because you want to reduce risk, you could choose to sell your position in smaller portions over time, spacing out the capital gains. You can then diversify the remainder of your portfolio into assets whose values change based on different factors than the ones that influence the investment from which you are trying to diversify away. For instance, a company that is highly exposed to the demand for umbrellas would be affected by different factors than a company selling sunscreen. When evaluating your risk exposure, consider your portfolio as a whole, not only the investment in question.
While adjusting your portfolio, be wary of inadvertently increasing your exposure to a given investment. Investors can sometimes unwittingly buy mutual funds that expose them to a company or sector that they intended to avoid. If you want to diversify away from a concentrated position, you may find it useful to consider separately managed accounts. In such arrangements, investment managers create diversified portfolios of individual stocks that are customized to fit each client’s criteria.
Managing around your concentrated position is not your only option to avoid selling. Our colleague Eric Meermann discussed a number of sophisticated strategies to reduce risk without selling in his article “Hedging Strategies For Concentrated Equity Positions.” The techniques he discussed include buying puts, utilizing equity collars and investing in exchange funds. (We will discuss all three briefly, but see Eric’s article for more details.)
The first two of these are known as “options” strategies. They can allow you to protect yourself when you worry that an investment is too risky. Buying protective put options gives you the right to sell shares at a predetermined price. This allows you to place a floor under the value of your investment for a period of time. A protective put limits your potential losses while letting you partake in any future appreciation less the cost of the put.
An equity collar is an extension of the previous technique. This strategy involves both buying puts and selling call options. Call options are contracts that provide the right, but not the obligation, to buy a particular stock at a specified price within a certain window of time. The proceeds from selling the call options reduce the cost of the downside protection of the put, but they also limit the overall appreciation you can earn from the underlying investment. There is a cost to any options strategy, and you should remain mindful that you are only protected during the options’ terms.
An exchange fund — also known as a “swap” fund — allows you to invest a portion of your undiversified stock in the fund alongside other investors. (Note that these are different from exchange-traded funds, or ETFs, which are mutual fund-like securities that trade on stock exchanges.) In an exchange fund, a group of investors pool stock positions in a partnership. In exchange for their contributions, investors receive an interest in this new partnership. The result is a more diversified portfolio that should better track the market’s overall performance.
When you exit the exchange fund after a required participation period — usually at least seven years — you will receive a mix of stocks from the fund, equivalent to the fair market value of your partnership interest. You can defer capital gains tax until you sell the stocks you receive, but you have diversified your portfolio in the meantime. Exchange funds are not without their drawbacks, however. They carry higher fees than index funds. And while the new stock positions you receive when you exit the fund will be more diversified than the position you started with, they will still have a relatively low cost basis and remain somewhat concentrated. Your overall return will depend on the quality of the stocks your fellow investors contributed to the fund and the fund’s illiquid holdings (usually real estate).
As we mentioned in part one of this series, donating appreciated securities to a charity can allow you to get rid of an appreciated asset without owing taxes. Giving stock directly to a charity is simple, but investors with philanthropic aims may find a more complex strategy better fits their goals.
A donor-advised fund, often abbreviated DAF, allows a donor to maintain more flexibility than an outright gift. A donor contributes cash, appreciated securities or other assets to a DAF. Then, the managing organization holds the funds in an account in the donor’s name, which can be invested tax-free. The contributions are irrevocable, but the donor can recommend distributions to charitable recipients at any time. A donor-advised fund allows you to take a tax deduction for all contributions when you make them — subject to Internal Revenue Service limitations — even though the money may be distributed to individual charitable recipients at a later date. Like making a direct gift, donating appreciated securities to a tax-exempt organization via a DAF means that you can increase the size of your gift and reduce the size of your capital gains tax obligation.
Charitable trusts are great tools to split the beneficial enjoyment of your assets between you, your individual beneficiaries and charitable institutions you want to help. Establishing a charitable trust can help you avoid paying capital gains tax on appreciated investments while fulfilling your philanthropic goals.
There are two primary types of charitable trusts: charitable lead trusts and charitable remainder trusts. In a charitable lead trust, a charity receives an annual series of payments — either a fixed percentage of the trust’s value or a fixed dollar amount — each year. At the end of the trust’s term, a noncharitable beneficiary such as a family member receives the remainder of the trust assets. A charitable remainder trust is essentially the mirror image of a charitable lead trust. In a charitable remainder trust, the noncharitable beneficiary receives annual payments, and the charitable beneficiary receives whatever is left at the end of the trust’s term.
Charitable remainder trusts provide the grantor (the individual setting up the trust) with an upfront tax deduction for the amount projected to eventually pass to charity, and the trust can sell assets without incurring a tax liability. This makes charitable remainder trusts generally the better choice for diversifying a concentrated portfolio while maintaining an income interest for noncharitable beneficiaries. Despite the benefits of a charitable remainder trust overall, note that the trust distributions to individuals are still taxable income.
Like all trusts, charitable trusts can be expensive and complex to set up and maintain. You will want to consult experienced professionals to ensure the trust is structured to reflect your intentions. (To learn more about charitable trusts and DAFs, see Eric Meerman’s article “Creative Approaches To Charitable Giving.”)
Private foundations are powerful giving vehicles, but they entail substantial financial, administrative and legal burdens. While a private foundation will likely not make sense as solely a capital gains tax planning strategy, if you wish to set up a foundation for other reasons, it can serve as a tax planning tool as well. When you contribute appreciated stock to a private foundation, you are entitled to an income tax deduction for the stock’s fair market value. By extension, any contributions of appreciated assets will also avoid capital gains tax. However, due to the Taxpayer Certainty and Disaster Relief Act of 2019, if the foundation sells the assets in the future, it will pay an excise tax of 1.39% on net investment income.
Private foundations are governed by complex rules and limitations that are extensive and beyond the scope of this article. If you want to learn more about them, see our colleague Melinda Kibler’s article “Private Foundations Can Work For Some.”
Section 1202 Planning For Small Businesses And Their Investors
If you’re looking to avoid capital gains on the sale of stock in a small business, you will find it useful to understand the rules governing qualified small business stock as defined by Section 1202 of the Internal Revenue Code.
If your situation fits the criteria outlined in Section 1202, you can exclude up to 100% of capital gains on the sale of QSBS, up to the greater of $10 million or 10 times the stock’s aggregate original cost basis. The limit applies for each company, so if you hold stock in multiple companies, the maximum amount applies for your holdings in each of them.
The rules of Section 1202 apply to entrepreneurs starting a business and investors in qualifying companies. Therefore, it’s important to understand the rules if you will be starting or investing in small businesses. If you start your own business, considering these rules in advance can help you make the most of them. Those hoping to benefit from Section 1202 planning should be mindful of how they structure their business, as these rules only apply to C corporations, not S corporations or LLCs.
Not all small businesses structured as C corporations qualify for the benefits of Section 1202. The Internal Revenue Code outlines the following parameters for a business’s stock to qualify:
- The stock must be held by noncorporate shareholders such as individuals, trusts and estates.
- The stockholders must hold the stock for more than five years.
- The stock must be issued by a domestic C corporation other than one involving personal services; banking, insurance, financing, leasing or investing; farming; mining; or operating a hotel, motel or restaurant.
- On the date of the stock is issued, the corporation must have $50 million or less in assets.
- The small business must be an active business with at least 80% of its assets used in a “qualified trade or business.” (This is to ensure the corporation is an operating business and not simply an investment vehicle.)
- The stockholders must acquire the stock in exchange for money or property, or as pay for services the stockholders provided to the corporation. Someone who acquires small business stock from another person usually cannot take advantage of the tax break for gain on the stock’s sale.
If your situation fits these rules, you can exclude a portion of the gain on the sale of stock depending on when you acquired it. The excludable gain is 50% for stock acquired between Aug. 11, 1993 and Feb. 18, 2009; 75% for stock acquired between Feb. 19, 2009 and Sept. 27, 2010; and 100% for stock acquired after Sept. 27, 2010.
Even if the tax benefits of Section 1202 apply, you can lose them if you are not careful. In particular, transferring QSBS can become complex, but these complexities are beyond the scope of this article. Before you transfer stock that qualifies for Section 1202 benefits, be sure to consult a knowledgeable tax professional.
For investors with unrealized capital gains from investment real estate, Section 1031 exchanges could be helpful. Enacting a 1031 exchange allows you to defer capital gains taxes by swapping your appreciated investment of real estate property for another property of the same type. Under the current rules, only real estate qualifies for an exchange, so you cannot exchange a partnership interest or other investment. In addition, you can only exchange like-kind properties and IRS rules limit the use of 1031 exchanges for personal-use vacation properties.
With valid 1031 exchanges, you can effectively change the property you own without an outright sale and without realizing taxable capital gains. Because there is no limit on how frequently you can enact 1031 exchanges, you could roll over the capital gains on your real estate investment through various properties for years without owing tax until you sell a property outright.
Qualified Opportunity Zones
Since 2019, the Qualified Opportunity Zone program has offered tax incentives for those who invest capital gains into certain projects designed to spur economic development and job creation in economically distressed communities. Anyone can defer capital gains in this manner, but the circumstances need to be right in order to secure the tax incentives. The program applies to either short-term or long-term capital gains.
To reap the program’s benefits, you must invest your gains in a Qualified Opportunity Fund: a partnership or corporation that holds at least 90% of its assets in Opportunity Zone property. Investors can defer paying the capital gains tax until 2026 on any capital gain they reinvest in a QOF within 180 days. QOF investors can also exclude all subsequent appreciation in the investment if they hold their position for at least 10 years. It is important to note that investing in a QOF with something other than a capital gain means you will not receive the offered tax deferral. The program’s intricacies mean you should spend time educating yourself, consulting a professional or both before you participate. For more information on Qualified Opportunity Zones, see Melinda Kibler’s article “Making The Most of Opportunity Zones.”
Capital gains tax planning, like most tax planning, is not a one-time event. It requires not only a clear understanding of your goals, but also an awareness of the techniques available to you. Whether you’ve already realized a capital gain or you expect to realize one years from now, you can benefit from careful planning, potentially including one of the techniques we have described. However you proceed, be careful to comply with IRS rules and to meet the various requirements involved in these more complex techniques. Tax avoidance, or lowering your tax bill using legal means, is perfectly acceptable; tax evasion is illegal and can carry serious consequences. As your capital gains tax planning grows more complex, take special care to be sure you pay what you owe, no less … and no more.