Pity that poor billionaire Philip Anschutz. He tried to cash out of positions in Anadarko and
Don't let this happen to you. There are ways to duck cap gain taxes. We'll look at several classic techniques.
None is perfect. It's impossible to lock in a gain and pocket the proceeds without exposing yourself to the tax collector. You might have to forgo the enjoyment of your gain (see method No. 3) or cough up some cash (No. 4) or take some risk (No. 5). Still, if you are in a high tax bracket, you should be thinking about all these options.
There was a time when the tax avoidance game was easier to play. You could hold onto appreciated stock while eliminating risk by setting up an offsetting short position ("shorting against the box"). Congress took away that gambit. It has also made exchange funds (in which you trade in appreciated stock for shares in a diversified pool) not worth the bother.
Taxes on capital gains are going up. The maximum federal rate for long-term gains is going from 15% now to 20% in January, absent an extension of the Bush tax cuts (very unlikely). State and local taxes can easily add 10 points to this rate. Being able to deduct state and local income taxes on your federal return softens the bite but is not permitted for the many taxpayers afflicted by the alternative minimum tax.
Here's what's left in cap gains tax avoidance.
No. 1. Donate.
Say you bought some
It doesn't make sense to transfer shares for small gifts. Solution: Use one of the charitable gift trusts that brokers offer. You donate one block of appreciated stock and use that to fund lots of small gifts over a period of years. (The stock is sold by the trust, not by you, and the trust doesn't pay capital gain taxes.)
Fidelity Investments says that it has helped customers give away $10 billion with its charity trust. Its minimum to open an account is $5,000 and its gift minimum is $50. The fee is 0.6% of assets annually plus the cost of whatever fund you invest the money in.
No. 2. Transfer.
Give your appreciated stock to a relative in a lower tax bracket--say, your impoverished daughter, now attending med school. She sells it to pay expenses. The gain (starting from where you bought the stock) goes on her tax return and could be taxed at a rate as low as 0% this year and 10% next.
Drawbacks: This doesn't work for youngsters or for large sums. Under the "kiddie tax" rules, the transfer accomplishes nothing if the recipient is a full-time student under 24. Also, any gifts over $13,000 eat into your lifetime gift/estate exclusion.
No. 3. Die.
Except for people dying in 2010, there's a "step-up" that means you (and your heirs) never pay income tax on the appreciation between when you bought an asset and when you die. There's something to be said for hanging onto your winners and leaving them to the next generation.
Rich people have been playing this game for years. They don't sell assets, they borrow against them. That way, they can come up with the cash to cover the yacht payroll without realizing any capital gains.
For 2010, federal law is governed by a congressionally mandated state of chaos. This year only, the estate tax is repealed and the step-up is limited to $3 million of assets going to a spouse plus $1.3 million of other assets. A sunset provision restores the estate tax (and a broad step-up) next year. No telling whether the statesmen on Capitol Hill will retroactively undo the law now in effect.
No. 4. Buy a put.
Example: You own some low-basis
Let's say this blue chip crashes to $40 over the next 17 months. The option will then be worth $20. Your $13 profit on the option will soften the blow of losing $20 of your appreciation on the stock.
Drawbacks: Crash insurance is expensive, and the tax rules on protective puts are somewhat unattractive.
Put options are costly because they allow you to enjoy gains (P&G might go to $120) without suffering any losses. But if this stock goes sideways for a decade you are going to get poor buying options over and over again at $7 each.
As for taxes: The put purchase does not get in the way of your immediate objective, which is to avoid paying cap gains taxes on the P&G appreciation. But it has its own tax issues.
If the stock crashes, the put becomes valuable and you have to do something with it. You could exercise the option, delivering the shares at $60 and paying tax on the whole thing. Or you could sell just the put, realizing a short-term gain on that.
If the stock goes up or sideways, the put expires worthless. You are not permitted to deduct the $7 loss on the put. Instead, the $7 gets added to your cost basis for the stock, lowering your eventual capital gain if you do sell the P&G shares.
Still, the put strategy could make a lot of sense if you are now living in high-tax New York City and plan to be retired to low-tax Miami before the put expires. For option prices, go here.
No. 5. Sell a call.
You could sell call options against your P&G. A $50 January 2012 in-the-money call was recently fetching $13. Selling the call does not eliminate your despair if your blue chip goes the way of General Motors. But at least you are not in the poor house. The $13 is yours to keep.
The option premium is not taxable income to you right away. If you allow the option to be exercised, you will record $63 as the sale price of your P&G and, provided you had held this stock for more than a year at the time you wrote the option, the sale will be taxed at low long-term rates.
More likely, you will buy the option back before it expires. In that case your gain or loss on the option trade will be a short-term gain or loss, no matter how long you have held the option.
Let's say P&G is still worth $61 in January 2012. Then the call you have sold short can be bought back for $11, and your $2 profit goes on your tax return as a short-term capital gain.
No. 6. Combine No. 4 and No. 5.
Sell a call and buy a put. This is a popular tactic since, if you pick the right strike prices, you're not out any cash.
You can reduce risk with this transaction. But not eliminate it. If you take away too much risk the IRS will come after you. Suppose that both the put option and the call option are exercisable at $60. Then, no matter which way the stock goes, it is foreordained that you will be getting out in 2012 at $60. As far as the tax collector is concerned, you are out now. The option trade will make your gain on the P&G immediately taxable.
So put some air space between the strike prices. You could, for example, sell a $70 call and buy a $45 put. They were both recently trading near $2.50. If the IRS visits, you can say you still have a stake in P&G's fortunes.
How large a spread do you need to keep the taxman at bay? Robert Gordon, whose firm Twenty-First Securites specializes in tax-wise hedging strategies, says that a call strike price that is 15% to 20% above the put strike price should do the trick.
Viva Hammer, a tax lawyer now at KPMG, was at Treasury when the government was contemplating issuing specific rules on "constructive sales" like this. The rules never came out. But, she says, the thinking was that the spread ought to be wider for volatile stocks and for long-dated options.
Anschutz got into trouble not because his spread wasn't wide but because he made the mistake of lending his shares to the traders in the middle so they could do their own hedging. If you are buying and selling listed options then you don't have to lend shares as part of the same transaction and you probably don't have to worry.
