The end of 2020 cannot come fast enough. However, despite our exuberance to turn the page on this horrible year, there are still tax planning steps that investors can take to keep as much in their pockets as possible come April 15. Perhaps the area over which individuals have the most control is the recognition of capital gains.
Uncle Sam wants a piece of any income you may receive, regardless of the source. But there are significant differences in how various types of income or profits are taxed. Very broadly, ordinary income like wages, commissions, bonuses and rents, is taxed according to the IRS tables that specify increasing rates of taxation for higher levels of income. Ordinary income tax rates begin at 10% and increase to 37% of income above $622,000 for married couples.
A capital gain is a very different animal and represents the net profit earned by selling an asset (sometimes referred to as a "capital asset"). The difference between the selling price and the cost (or "adjusted basis" net of expenses) is called a capital gain and is a one-time event rather than a flow like wage income. Capital gains are taxed in a different manner than ordinary income, based upon the timing of the sale and the length of time the asset was held, giving the investor the ability to determine when to incur the tax.
The 16th Amendment, ratified in 1913, allowed Congress to impose federal income taxes on citizens of the various states (the top tax rate at the time was 7% on income above $500,000). By 1921, capital gains were carved out as a separate class of income and have historically been accorded a privileged status compared with wage income. While your paycheck is taxed each year, taxes on appreciation of capital assets like stocks and real estate are only triggered by the sale of the asset, creating a theoretically indefinite deferral of tax liability that increases the net return on the investment much like a retirement account might do. And in addition, appreciated assets are subject to a "step-up" in basis at the owner's death, wiping out any tax that might have been owed had the owner sold out before checking out.
The maximum rate of federal taxation on capital gains has varied dramatically over time, from a high of nearly 40% during the 1970s to a low of 15% through the early 2000s. Today, most taxpayers are subject to a 15% rate on long-term gains (gains on assets held over one year), with the top rate going to 23.8% for married couples earning over $496,600. Short-term gains on holdings of less than one year are taxed as ordinary income.
Another preferential aspect of capital gains is the ability to offset gains with current or prior losses on other sales. Investors may net together short-term gains and losses, long-term gains and losses, and then net the differences to figure their tax liability. Unused losses not applied during the tax year may also be carried forward against future gains.
As the end of the year approaches, there may be steps you can take to maximize this tax preference in your own portfolio (aside from retirement accounts, for which all taxes are deferred). If you have already realized a gain from the sale of an asset at a profit, review your positions to see if there is a turkey in there that needs to be trimmed, and use the loss to offset the prior gain. And even if you still believe in a stock or fund that is in the tank, you may sell the position to lock in a loss and then buy it back after 30 days.
Death and taxes, yes. But at least with capital gains, you have a little control over the timing.
Christopher A. Hopkins, CFA, is vice president and portfolio manager for Barnett & Co. in Chattanooga