Welcome to today’s show. This is episode 11, 2023, Capital Gains Tax basics. This is an extremely important topic because in 2018, the federal government collected over $170 billion of capital gains taxes. We need to understand what is a capital asset? When is it taxed? How is it taxed? And are there strategies that we can utilize in our Estate Planning to avoid the payment of capital gains tax in a legal and lawful manner? Well, let us dive in.
Let us first talk about what is a capital asset? Well, the Internal Revenue Code basically describes a capital asset as any tangible/intangible or real property unless it is otherwise excluded by the tax code, and trust me, there are very few exclusions. What is gain? Well, if we own a capital asset and purchase it for one price, and sell it for a higher price, very simply put, the difference between the two is called gain. Now, it is not quite that simple. For instance, we may purchase real estate, say for $10,000 and make some improvements to that property, let us say of $2,000, and then later sell that property for 20,000. What’s the gain? Well, the law allows us to take the purchase price of $10,000 and create what is called adjusted basis by adding the $2,000 worth of improvements to the initial basis, so that our adjusted basis is 12,000, and then when we sell the property for $20,000, that will allow us to subtract the two to net out an $8,000 gain. Obviously, we can also have losses, and the law will allow us to deduct those losses up to a certain amount on our income taxes that we file on an annual basis. Now, it is extremely important to understand right off the top, that the tax code treats long-term capital gains different than short-term capital gains. What is a long-term gain? Well, it is the gain or loss on a property, a capital asset that we hold for more than one year. Very simple, we either did or did not hold it for more than one year. If we did, it is going to be subject to the long term capital gain or loss rates and rules. Anything that we hold less than a year will be subject to the short-term capital gain rules.
Right off the top, what is the difference? Well, for short term capital gains, it is important to understand that they are taxed at a higher rate. They are taxed at the same rate as our wages. In essence, they are subject to the ordinary income tax rates. A capital asset that is held for more than a year for public policy reasons is subject to a lower tax rate. Let us talk about then the tax rates for long-term capital gain. What are these lower preferred rates? Well, what is interesting is the rates that are assessed by the government depend upon an individual’s taxable income in a given year. The rates are really one of four rates that we have to look at. First, it is possible to have a gain subject to a 0% tax rate. The second rate and the more common one is 15%. The third and higher for our high income earners is 20%, and furthermore, recently, the federal government has added the net investment tax, which adds an additional 3.82% for our high income earners. So, with respect to our 0% capital gains tax bracket in 2023, if a person’s taxable income is under $83,350 for a married couple, or $41,675 as a single individual, if they have a capital gain, and the gain plus their other income is lower than those amounts, they will pay no capital gains tax on any gain that they realize. The 15% tax rate for a married couple goes all the way up to $517,300 while the individual bracket goes up to $458,750, that is that if the total taxable income is below those amounts, then the capital gains tax rate is 15%. Just understand that the taxable income amount includes the amount of the gain that is realized in the sale in question to the extent that we have income that is higher than those amounts, then the capital gains tax rate is going to be at the 20% tax rate, and there will be a net investment tax that gets added in at certain taxable income levels. So, it is important to understand what is a capital asset? How is gain calculated? Number three, the difference between short-term and long-term, and then understanding what the tax rates are at the different brackets. Next, how do you report capital gains? Well, there is a schedule called schedule D on the individual 1040 tax return that gets attached, and that is where the capital gains are reported.
Now let us talk about the possibility of there being some strategies that we might be able to follow to either minimize or completely eliminate the long-term capital gain amount that we are going to have to pay. So, it is important to understand that there is an exclusion for the sale of our personal residence. The exclusion for our home is capped for a single person in 2023 at $250,000 worth of gain or for a married couple is capped at $500,000. One strategy that some individuals have is say they invest in an investment property and then want to sell it. Well, what they will do prior to selling it is make sure that they move into the property and live there for two out of the preceding five years, and then when they sell it, it will be subject to the exclusions that I mentioned. Another way to eliminate or at least minimize the long-term capital gains tax rate is to engage in what is called an installment sale. For instance, if you have $200,000 worth of gain all in one year, you are likely to be subject to the 15% tax rate, depending upon of course what your taxable income is. But if you have a fairly low amount of taxable income, let us say you are 70 years old and retired and are living on Social Security, and you sell a capital asset and obtain a $200,000 gain, if you take that $200,000 gain and spread it over the course of let us say 10 years, the gain per year then will only be $20,000, and if you are a single person and your total income falls below the 41,675 or if you are a married couple and it falls below $83,350, there will be a 0% capital gains tax rate. So, an installment sale is a common method utilized in an attempt to minimize capital gains taxes.
It is also important to understand that another basic way to minimize capital gains taxes is to make sure that you hold the asset for longer than one year, so you are not subject to the short-term capital gains tax rates, and it is simply required to be more than one year. Another common way to avoid the capital gains tax rate is to engage in something that is called a 1031 exchange involving real estate. So, let us say you have investment property, not your residence, but investment property, and let us say that you have a tax basis of $100,000, and let us say that property has appreciated significantly in value, and you are going to be able to sell it in 2023 for 200,000, and realize, let us just say $100,000 gain to make it simple. If you follow the 1031 exchange rules, and by the way, I will do a separate podcast on 1031 exchange rules if you are interested, but let us just say that you have identified another piece of property that you would like to purchase, or the law will allow you to take the gain that you have gotten from the sale of this property, and if you follow the rules, utilize that gain to purchase a new property and not have to pay the capital gains tax. Now there are some very specific rules – one, it has to be a like-kind exchange, and two – there are some specific time periods, and the name on the initial property that is being sold versus the one that is being purchased have to be the same along with some other rules, but that is one way to make sure we defer capital gains tax on real estate.
Similarly, as it pertains to life insurance products, we can do what is called a 1035 exchange. It involves both life insurance and annuities. So, what we are able to do is to take an old, dated life insurance policy that has cash value in it, and we are allowed to exchange it into a new policy. What some of our clients are doing these days, with both their life insurance policies, as well as their annuity contracts is they are doing 1035 exchanges into new policies that have long-term care benefits attached to those policies. This is a very significant way of doing a tax free exchange into a policy that will provide substantial long-term care benefits, which are ultimately paid out on behalf of our clients, either tax free in long term care benefits, or tax free through a death benefit. So, 1031 and 1035 exchanges are popular, and I will be doing a detailed podcasts about each of those strategies in the future.
Let us talk a little bit about tax loss harvesting. You know over recent years, a number of my clients are meeting with their financial advisor towards the end of the year, indicating to me that while they have had some capital gains, they have also had some capital losses. One of the things that you realize is that they have the ability to offset losses against gains if those losses are harvested. Well in order to harvest a loss, the underlying stock or what have you will have to be sold, but it will allow once the losses are netted against the gains to reduce the amount of capital gains tax that are owed. Furthermore, the Internal Revenue Code will allow an individual to take an additional up to $3,000 worth of capital losses on an annual basis. If you end up with more than $3,000 worth of capital losses, you will be able to carry them forward into subsequent years. So, those are always a good strategy.
Another strategy to eliminate the payment of capital gains tax is simply to take a highly appreciated asset, let us say, an individual stock that you may own, and donate that stock to charity. When the charity takes ownership of that stock and sells it, because they are a charitable institution, they will pay no capital gains tax on that, and if you meet the fairly stringent charitable deduction requirements, you may be able to write off some of the charitable contributions that you have made. That is one significant way a number of our clients are minimizing, or eliminating the capital gains tax on highly appreciated assets, but the more common thing to do for most people, is to understand the concept of step-up in tax basis. Just remember, capital gains tax are not paid until the asset is sold. If you have a capital asset that you own, that is highly appreciated in value, in other words, there is substantial gain. Rather than gifting that asset during your lifetime to your family members, or rather than selling that asset, and having to recognize long-term capital gain, if you hold that asset until death, and it becomes part of your taxable estate, and then your family sells that asset after you pass away, there will be no capital gains tax paid, because the asset was held until death and your tax basis goes away, and a new tax basis, the fair market value of that asset on the date of your death is the tax basis that your family members now have, and if they turn around and sell that asset, the bottom line is the IRS will consider the tax basis on your dated death to be the sales price for what they sold it for and no capital gains tax will be owed because of the step-up in tax basis that happened upon your death.
Well, I hope that this gives you some idea and some clarity as it pertains to capital gains and the capital gains tax system that we have here in the United States. Based upon the current numbers, I think it is more important that we educate our clients about capital gains and taxes and some of the strategies that can be utilized in order to minimize or eliminate the payment of capital gains taxes. Thanks for being with me today. I hope you enjoyed this podcast. Have a great day. Thank you so much.
