When asking “How can you avoid capital gains tax?”, the most common way is to either reduce, defer, or eliminate the tax through proper planning prior to selling an asset.
Start by determining the amount of money you originally invested in an investment (your cost basis), how long you have owned that investment (holding period), what you anticipate to earn as taxable income this year, and what type of asset you own. Where the money is invested also affects the taxes you will pay on it. Understanding the difference between an individual retirement account ira vs 401k can assist you in deciding where to make future investments to maximize tax savings.
How Can You Avoid Capital Gains Tax Legally?
Hold the Asset for More Than One Year
The short-term gain from assets that have been owned for less than a year will usually be subject to the same tax rate as the taxpayer’s regular income. Assets that have been owned for more than one year are eligible for long-term federal capital-gain tax rates of 0%, 15%, or 20%. The applicable rate is determined by the taxpayer’s taxable income and filing status. Additionally, some high-income taxpayers could potentially be subject to the 3.8% Net Investment Income Tax.
When you’re approaching your first year of holding an asset, consider whether to wait and realize tax benefits or take on the risk of keeping it.
Offset Gains With Capital Losses
The tax-loss harvesting technique is a method of selling off an investment at a price lower than what was paid for it (basis) in order to use those losses to offset any realized gains you may have. When your losses exceed your gains, you are usually allowed by the Internal Revenue Service (IRS) to apply a maximum of $3,000 of net capital loss against your ordinary income, and then carry forward the excess.
Watch for the wash sale rule. If you purchase the exact same security (or one that is substantially similar) during the wash-sale period, then you may not be able to claim your loss immediately.
Use Tax-Advantaged Accounts
In addition, when you trade inside of a qualified retirement account, it will not produce a capital gain that would otherwise be subject to income tax in the current year. On the other hand, if you were to trade using a taxable brokerage account, you would have to pay taxes on any capital gains you realized from those trades in the year they occurred. In general, traditional retirement accounts allow individuals to defer paying taxes on their contributions and earnings until they begin withdrawing money from the account. Conversely, qualified Roth withdrawals are typically free of income tax.
Read more: lottery winnings after taxes calculator
Time Gains for Lower-Income Years
The tax rate for long-term capital gains can be zero percent if your taxable income is low. Therefore, a low-income time (e.g., during the first few years of retirement, or in-between years where there was a significant amount of money earned) might be a good time to take advantage of this lower tax on realized gains.
Always consider your total tax picture; a big profit can impact your state income taxes as well as the net investment income tax (NIIT).
Use the Home-Sale Exclusion
If you have lived in and owned your primary residence for a minimum of two years prior to selling it within the last five years, then you may be able to exclude up to 250,000 of the gain (500,000 for married couples filing jointly).
You should keep records of any qualifying improvement to your property as it may change your adjusted basis and thus impact your potential taxable gain. While there are different types of “windfalls” that have their own set of rules (for instance, the differences between Mega Millions and Powerball do not alter the capital gains exclusion available on your residence), the same general principle applies.
Consider a 1031 Exchange
Section 1031 exchanges allow you to defer taxes on any gains made from the sale of qualifying business/investment real estate that has been traded (exchanged) for similar real estate. These rules do not apply to your primary residence or any stock you may own. There are certain procedures that must be followed.
Donate Appreciated Assets
If charitable giving is part of what you are doing with your money, then directly giving the appreciated long-term assets to a qualifying charity can avoid having to pay on the capital gain in those assets. Additionally, there could be a charitable deduction available, depending upon how the IRS views the transaction and the IRS limits on the amount of deduction.
The Bottom Line
So, how can you avoid capital gains tax? There are several ways to reduce or eliminate your capital gains tax liability. One of the best methods is to plan ahead of time before you sell the property. If you have received any of your assets via inheritance, then you may also need to consider what the requirements are for distributions from your retirement account, including but not limited to the calculation of your required minimum distribution (RMD) on an inherited IRA.
Windfall Advisors will work with your tax professional(s) to coordinate the various aspects of both your investment and wealth-planning decisions; however, all personal tax-planning should be provided by a certified public accountant or other similar professional, who can assess the entirety of your financial situation.
Read more: How to calculate inherited IRA RMD?
Can you legally avoid capital gains tax?
Yes, certain strategies can legally reduce, defer, or sometimes eliminate capital gains tax. Eligibility depends on the asset type, holding period, income, and specific IRS rules.
How long do you need to hold an asset to reduce capital gains tax?
Holding an investment for more than one year generally allows gains to qualify for lower long-term capital gains tax rates. Short-term gains are usually taxed as ordinary income.
Can capital losses reduce capital gains tax?
Yes. Capital losses can offset capital gains, and excess net losses may offset up to $3,000 of ordinary income annually. Additional losses can generally be carried forward.
Can you avoid capital gains tax when selling a home?
You may qualify to exclude up to $250,000 of gain, or up to $500,000 for many married couples filing jointly. IRS ownership and residence requirements must be met.