You may be subject to capital gains tax when you gain from the sale of an asset, such as a business, land, or shares. Capital gains are sometimes taxed at the same rate as ordinary income, which can be as low as 0% or high as 37%, depending on the tax category. However, there are some effective strategies that investors use to offset capital gains tax.
Here are some of those strategies that can help reduce the tax burden of capital gains.
Wait more than a year before selling.
When a property is held for more than a year before being sold, it qualifies for long-term status, which lowers the capital gains tax rate. Long-term capital gains are usually taxed at 0%, 15%, or 20%, while short-term capital gains are taxed at regular income rates, depending on the tax category. As long-term capital gains are generally taxed at a more favorable rate, it is recommended that you hold the assets for at least a year before selling them.
Tax Loss Harvesting
Capital gains can be offset by losses incurred during the year or by carrying them forward from a previous year through a strategy known as tax-loss harvesting. By recovering tax losses, investors can reduce their tax consequences by selling their securities at a loss. If gains are less than losses, taxpayers can use up to $3,000 per year to offset regular income against income tax.
Using an example, let's say you made $12,000 with Asset X, but Asset Y lost $3,000. By selling Asset Y at a loss, you can offset the income from Asset X and pay $9,000 in tax instead of $12,000 in total. If the loss on Y was greater than the gain on X, you can offset the entire gain and deduct $3,000 from your taxable income.
Always sell when your income is lower.
If you or a spouse recently lost or quit your job or are about to retire, selling in a low-income year may put you in a lower tax bracket. You can reduce the tax rate on your capital gains by introducing a lower tax category.
Reduce your taxable income
Reducing taxable income is a great way to potentially reduce the short-term capital gains tax rate, as it is based on income. You can take full advantage of credits and deductions before you file your tax return or when you contribute to a 401 (k) or traditional IRA. There are other ways to reduce taxable income, such as investing in municipal bonds. Interest on most municipal bonds is tax-exempt from federal and some state taxes. To get more credits and deductions to reduce taxable income, the IRS provides a database of credits and deductions for individuals.
Defer capital gains with 1031 Exchange
A 1031 exchange lets investors sell a real estate investment and transfer their sale proceeds to a replacement property of the same type. By performing a 1031 exchange, investors defer capital gains tax indefinitely as long as they continue to reinvest the principal in the property. Assets can be swapped until death, and beneficiaries can receive a one-time base increase, potentially eliminating capital gains tax. The rules for a successful 1031 exchange are complicated and follow a strict schedule. This strategy also requires the help of a qualified broker.
Not only the wealthy can offset capital gains taxes. By knowing the right strategy for you, you, like most taxpayers, have the potential to offset capital gains. Consult a tax expert to make sure you qualify for certain deductions.
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