Although plenty of people have made money on the stock market this year, there are many others who have recognized losses on securities, or may be thinking of bailing out of other holdings that show paper losses.
It is critical to plan the most appropriate year-end planning strategy for an individual’s capital gains and losses will depend on a series of factors, including the amount of regular taxable income, the tax rate that applies to the individual’s “adjusted net capital gain”, whether recognized capital gains are long- or short-term, and whether there are unrealized capital losses.
Capital gain and loss basics. As explained in more detail below, an individual’s “adjusted net capital gain” is taxed at maximum rates of 0%, 15%, or 20%. “Adjusted net capital gain” is net capital gain plus qualified dividend income, minus specified types of long-term capital gain that are taxed at a maximum rate of 28% (gain on the sale of most collectibles and the unexcluded part of gain on Code Sec. 1202 small business stock) or 25% (“unrecaptured section 1250 gain”—i.e., gain attributable to real estate depreciation). “Net capital gain” is the excess of net long-term capital gains (from sales or exchanges of capital assets held for over one year) over net short-term capital losses for a tax year. Net short term capital gains (i.e., from the sales of capital assets held for one year or less before being sold) are taxed as ordinary income.
Long-term capital losses are used to offset long-term capital gains before they are used to offset short-term capital gains. Similarly, short-term capital losses must be used to offset short-term capital gains before they are used to offset long-term capital gains. Noncorporate taxpayers may use up to $3,000 of total capital losses in excess of total capital gains as a deduction against ordinary income in computing adjusted gross income (AGI).
Capital gain tax rates. As a result of the Tax Cuts and Jobs Act (TCJA; P.L. 1115-97, 12/22/2017), for 2018 through 2025, the taxpayer’s ordinary income tax rates are not factors in determining how adjusted net capital gain is taxed. Instead, the rates that apply to such gain are determined with reference to dollar amounts set forth in the Code (subject to inflation adjustment after 2018). (Code Sec. 1(j)(5))
- The 0% tax rate applies to adjusted net capital gain to the extent that it, when added to regular taxable income, is not more than the “maximum zero rate amount” ($77,200 for joint filers and surviving spouses, $51,700 for heads of household, $38,600 for single filers, $38,600 for married taxpayers filing separately, and $2,600 for estates and trusts);
- The 15% tax rate applies to adjusted net capital gain to the extent that it, when added to regular taxable income, is over the amount subject to the 0% rate, but is not more than the “maximum 15% rate amount” ($479,000 for joint filers and surviving spouses, $452,400 for heads of household, $425,800 for single filers, $239,500 for married taxpayers filing separately, and $12,700 for estates and trusts); and
- The 20% tax rate applies to adjusted net capital gain to the extent that it, when added to regular taxable income, is over $479,000 for joint filers and surviving spouses, $452,400 for heads of household, $425,800 for single filers, $239,500 for married taxpayers filing separately, and $12,700 for estates and trusts. (Code Sec. 1(h)(1); Code Sec. 1(j)(5)(A))
Illustration (1): For 2018, Mr. and Mrs. Smith have $75,000 of taxable income exclusive of capital gains, plus $8,000 of long-term capital gains from the sale of stock. They have no other capital gains and losses for the year.
- A zero (0%) tax rate applies to $2,200 of their long-term capital gain ($77,200 – $75,000); and
- A 15% rate applies to $5,800 of their long-term capital gain ($8,000 – the $2,200 that is subject to the 0% tax rate).
Thus, the tax on the Smiths’ $8,000 of long-term capital gain is $870 (15% of $5,800).
Under Code Sec. 1411, there is a 3.8% surtax on net investment income (including capital gains) of noncorporate taxpayers whose modified adjusted gross income exceeds $250,000 for joint filers and surviving spouses, $125,000 for separate filers, and $200,000 in all other cases. If this surtax applies, it will result in a maximum tax rate of either 18.8% (15% + 3.8%) or 23.8% (20% + 3.8%) on adjusted net capital gain, depending on taxable income.
Year-end strategies for capital gains and losses. Keeping in mind that investment factors are paramount when deciding to sell or hold capital assets, here are year-end strategies that can produce significant tax savings.
- Taxpayers whose 2018 taxable income from long-term capital gains and other sources is below the zero rate amount should try to avoid recognizing long-term capital losses before year end as they may receive no benefit from those losses.
Illustration (2): For 2018, if marrieds filing jointly have $70,000 of taxable income exclusive of capital gains, plus $5,000 of long-term capital gain from the sale of stock earlier this year, none of that gain will be taxed. If they unload mutual fund shares showing a $5,000 long-term paper loss, they will receive not a tax benefit from that loss.
- Taxpayers whose 2018 taxable income will be below the zero rate amount should consider recognizing enough long-term capital gains before year-end to take advantage of the 0% rate. For example, joint filers who anticipate having $67,000 of taxable income for this year, exclusive of capital gains, could recognize up to $10,200 of long-term capital gains before year end, and none of the gain would be subject to tax ($77,200 zero rate amount – $67,000).
- Taxpayers who have no capital gains should consider selling enough loss securities to yield a $3,000 capital loss, which can be used to offset ordinary income.
- Taxpayers should consider selling capital assets showing a long-term gain this year rather than next if their gains would be subject to a higher capital gain tax rate next year. Conversely, taxpayers should put off recognizing long-term capital gains if next year’s capital gain tax rate is likely to be lower.
- Time long-term capital losses for maximum effect. A taxpayer should try to avoid having long-term capital losses offset long-term capital gains since those losses will be more valuable if they are used to offset short-term capital gains. To do this requires making sure that the long-term capital losses are not taken in the same year as the long-term capital gains are taken. However, this is not just a tax issue. As is the case with most planning involving capital gains and losses, investment factors need to be considered. A taxpayer won’t want to defer recognizing gain until the following year if there’s too much risk that the value of the property will decline before it can be sold. Similarly, a taxpayer won’t want to risk increasing the loss on property that he expects will continue to decline in value by deferring the sale of that property until the following year.
To the extent that taking long-term capital losses in a different year than long-term capital gains is consistent with good investment planning, the taxpayer should take steps to prevent those losses from offsetting those gains.
Additionally, it may pay for taxpayers who have already realized short- and long-term capital gains for 2018 to accelerate the sale of depreciated-in-value capital assets so that they yield a short-term rather than a long-term capital loss.
Illustration (3): Jennifer invested $10,000 in Crypto stock on Nov. 4, 2017. In September 2018, the value of the stock has dropped to $2,000. Jennifer thinks the chances of the stock increasing in value are slim so she plans to sell it. Jennifer is in the top 37% income tax bracket and also will be subject to the 3.8% surtax on net investment income. Earlier in 2018, she recognized short-term capital gains of $15,000 facing a tax of 40.8% (37% + 3.8%), and long-term capital gains of $20,000 facing a tax of 23.8% (20% + 3.8%). She does not anticipate any other trades for the year.
If Jennifer sells the Crypto stock before Nov. 5, 2018, she will recognize a short-term capital loss of $8,000 (assuming no change in value). This loss will offset $8,000 of her short-term capital gains for the year, thus producing a $3,264 ($8,000 × 40.8%) tax savings.
If, on the other hand, Jennifer waits and sells the stock after Nov. 4 but before Jan. 1, 2019, she will recognize an $8,000 long-term loss (assuming no change in value occurs). This loss will offset $8,000 of her long-term capital gains in the year of the sale, thus producing a $1,904 ($8,000 × 23.8%) tax savings.
By selling the Crypto stock before Nov. 5, 2018, and generating a short-term capital loss, Jennifer saves an additional $1,360 ($3,264 – $1,904) in taxes because of the difference in the tax rates applied to her short-term (40.8%) and long-term (23.8%) capital gains.
Preserve investment position after recognizing gain or loss on stock. For the reasons outlined above, paper losses or gains on stocks may be worth recognizing this year in some situations. But suppose the stock is also an attractive investment worth holding onto for the long term. There is no way to precisely preserve a stock investment position while at the same time gaining the benefit of the tax loss, because the so-called “wash sale” rule precludes recognition of loss where substantially identical securities are bought and sold within a 61-day period (30 days before or 30 days after the date of sale). Thus, a taxpayer can’t sell the stock to establish a tax loss and simply buy it back the next day. However, a taxpayer can substantially preserve an investment position while realizing a tax loss by using one of these techniques:
- Double up. Buy more of the same stocks or bonds, then sell the original holding at least 31 days later. The risk here is of further downward price movement.
- Sell the original holding and then buy the same securities at least 31 days later.
- Sell the original holding and buy similar securities in different companies in the same line of business. This approach trades on the prospects of the industry as a whole, rather than the particular stock held.
- In the case of mutual fund shares, sell the original holding and buy shares in another mutual fund that uses a similar investment strategy. A similar strategy can be used with Exchange Traded Funds.
Planning Idea….. The wash sale rule applies only when securities are sold at a loss. As a result, a taxpayer may recognize a paper gain on stock in 2018 for year-end planning purposes and then buy it back at any time without having to worry about the wash sale rule.