How To Avoid Capital Gains Tax
There are several legal tactics that you can use to reduce or avoid capital gains taxes altogether.
Hold Onto Your Investments
Holding onto your investments for at least a year is the most straightforward way to avoid paying the highest possible tax rates. This strategy works by avoiding the expensive short-term capital gains tax. This is especially beneficial if you’re selling a personal property and want to take advantage of the principal residence exemption (more on that below).
If one of your capital assets is quickly declining in value, such as stock in a struggling business, you may feel the need to sell it before holding it for a year to cut your losses. However, in our next example you can find how even capital losses can help you save money on your taxes overall if you realize the losses after owning the asset for over a year to take advantage of the long-term capital gains tax rates.
Use Your Capital Losses
Investors can minimize their capital gains tax liability when they sell their assets after a period of loss. Depending on the type of capital asset you’re holding, you can often use your capital losses to “cancel out” any gain you saw earlier in the year.
For example, let’s say you have owned Stock A for 2 years. You bought Stock A when it was worth $4,000, but it has since decreased to $2,000 in value. If you don’t expect the stock value to rebound to its former glory, you can sell it to offset gains from another stock sale. Let’s say you bought Stock B 3 years ago for $3,000 and you sell it for $6,000. Instead of paying capital gains taxes on the full $3,000 profit, you can use your capital loss from Stock A to decrease your total tax liability.
This can be a risky move because in order to take advantage of this strategy, you have to lock in your losses from an underperforming stock. That is why it’s always wise to consult a tax professional before taking action.
Utilize Tax-Advantaged Discounts
There are several ways to take advantage of tax rules to decrease your capital gains taxes. One of the most popular strategies is to invest through tax-deferred retirement plans like IRAs or 401(k) plans. When you buy and sell investments through these plans, you don’t have to pay capital gains taxes. You only have to pay taxes when you withdraw from the accounts during retirement. This system helps you save money in two ways. By not taking out money for capital gains, your investment is allowed to grow more over time. Then, when you need to take out money during retirement, your income will probably be lower, putting you in a lower capital gains tax bracket and saving you even more money.
Exclude The Capital Gains Tax On A Home Sale
You’re exempt from a large amount of capital gains taxes when selling your principal residence based on your filing status. If you’re single, you’re exempt from capital gains tax on the first $250,000 of profit on your home. If you’re married filing jointly, you’re exempt from capital gains tax on the first $500,000 of profit on your home.
However, there are some key requirements to classify your property as your principal residence:
- You must have lived on the property for the last 2 out of 5 years.
- You must live there for the majority of the year.
- You must provide documented proof that you live there, such as a voter registration or tax return.
- The property must be reasonably close to your place of employment.
- If you’re married, your spouse must also claim the same property as their primary residence.
Sell When Your Income Is The Lowest
As we’ve gone over, the percentage you’ll pay on your long-term investments depends on your income. If your income is close to increasing above a limit that will put you into a higher capital gains tax bracket, It’s a good idea to sell your investments when your income is lower. If you’re self-employed or on a variable income, keep track of your revenue throughout the year and sell assets when your income is lower. You can also sell your assets after you retire.
Donate Your Appreciated Assets
Donating appreciated securities to charity can help you avoid both capital gains taxes and ordinary income taxes. If you donate a stock that you’ve owned for more than a year that has increased in value, you don’t have to pay any capital gains taxes on it. While it is a very kind thing to do, it may not appeal to many that can’t afford to give away growing investments. However, donating an appreciated security can also save you money on your ordinary income taxes because you can use it as an itemized deduction. That means you can decrease your taxable income by the fair market value of the stock.
