Capital gains taxes can represent a significant cost to individuals and businesses alike when selling appreciated assets. However, with careful planning and the strategic use of tax tools, it is possible to minimize these taxes and, in some cases, defer them entirely.
This guide outlines the various strategies for reducing capital gains taxes, touching on both individual and business applications.
We will explore essential concepts such as asset holding periods, tax-deferred exchanges, charitable giving, tax-loss harvesting, and the use of retirement accounts and tax credits.
Understanding Capital Gains Taxes
Capital gains are the profits realized when you sell an asset for more than its purchase price. Depending on the asset’s holding period, capital gains can be classified into two types:
• Short-term capital gains: Profits from assets held for less than one year. These gains are taxed at ordinary income tax rates, which can be as high as 37% for individuals, depending on the tax bracket.
• Long-term capital gains: Profits from assets held for more than one year. Long-term capital gains enjoy preferential tax rates, typically 0%, 15%, or 20%, based on taxable income levels.
For businesses, capital gains can also arise from the sale of investments or property, which may be subject to additional taxes, such as depreciation recapture for real estate assets.
Key Strategies for Individuals and Businesses to Minimize Capital Gains Taxes
1. Long-term Holding Strategy
One of the simplest and most effective strategies for reducing capital gains taxes is to hold assets for more than one year. By doing so, you shift from short-term capital gains rates to more favorable long-term rates. This approach is particularly beneficial for high-income individuals and businesses.
• Application for individuals: By holding onto stocks, bonds, or real estate for more than a year, individuals benefit from a lower tax rate on their profits.
• Application for businesses: When selling business property or large investments, companies can use long-term holding strategies to lower their overall tax liability, especially if asset values have appreciated significantly over time.
2. Tax-Deferred Exchanges: 1031 Exchange
A popular tax strategy for real estate investors, both individuals and businesses, is the 1031 exchange. This provision allows you to defer paying capital gains taxes when you sell a property, provided that you reinvest the proceeds into another “like-kind” property of equal or greater value.
• Key benefits: The capital gains tax is deferred until you eventually sell the replacement property without conducting another 1031 exchange. In theory, this deferral could last indefinitely, especially when the property is passed on to heirs at a stepped-up basis, eliminating the capital gains tax entirely.
Businesses frequently use 1031 exchanges when upgrading facilities or commercial properties, thus allowing for tax-deferred growth.
3. Tax-Loss Harvesting
This strategy allows you to sell underperforming investments at a loss to offset your capital gains from other investments. Tax-loss harvesting reduces the taxable capital gains by the amount of the capital losses.
• Application for individuals: Investors can offset short-term gains, which are taxed at higher rates, with short-term losses. Excess losses (beyond gains) up to $3,000 can be deducted against ordinary income. If the losses exceed the $3,000 limit, the remaining amount can be carried forward indefinitely to offset future gains.
• Application for businesses: Businesses can also use tax-loss harvesting on investments held in taxable brokerage accounts, offsetting capital gains realized from sales of appreciated business assets or investments.
4. Retirement Accounts: IRAs and 401(k)s
For individuals, contributing to retirement accounts like IRAs (Individual Retirement Accounts) or 401(k)s is an excellent strategy to defer taxes on capital gains until withdrawals are made in retirement. These accounts allow investments to grow tax-free or tax-deferred, depending on the type of account (Roth or Traditional).
• Traditional IRAs/401(k)s: Investments grow tax-deferred, meaning you won’t pay capital gains taxes as long as the money remains in the account. Withdrawals are taxed as ordinary income during retirement.
• Roth IRAs/401(k)s: Contributions are made with after-tax dollars, but all qualified withdrawals in retirement are tax-free, including the capital gains.
5. Charitable Contributions of Appreciated Assets
Donating appreciated assets, such as stocks or real estate, to a qualified charitable organization allows you to avoid paying capital gains taxes on the appreciation and still claim a charitable deduction for the full market value of the asset.
• Application for individuals: If you own highly appreciated stocks, donating them directly to a charity rather than selling them can avoid the capital gains tax altogether while benefiting from a deduction.
• Application for businesses: Companies can donate appreciated assets, such as appreciated shares in a business, and receive a tax deduction for the fair market value without incurring capital gains tax.
6. Opportunity Zones
The Opportunity Zone Program encourages investment in economically distressed areas by offering tax incentives for reinvesting capital gains into Qualified Opportunity Funds (QOFs).
• Tax benefits:
1. Deferral: Capital gains taxes can be deferred if the gains are invested in a QOF within 180 days.
2. Reduction: If the investment in the QOF is held for at least 5-7 years, a portion of the original capital gains may be excluded from taxation.
3. Exclusion: After 10 years, any appreciation within the QOF itself is exempt from capital gains tax.
This program is especially beneficial for high-net-worth individuals and businesses with large capital gains, offering both tax deferral and long-term wealth-building opportunities.
7. Installment Sales
An installment sale allows you to defer capital gains taxes by receiving payments over time rather than all at once. The tax is paid gradually as the payments are received, spreading out the tax liability over several years.
• Application for individuals: Selling a business, property, or other high-value assets on an installment basis allows sellers to report only a portion of the capital gains in each tax year, keeping them in a lower tax bracket.
• Application for businesses: Companies selling large assets can benefit from installment sales to improve cash flow and reduce immediate tax obligations.
8. Qualified Small Business Stock (QSBS) Exclusion
For entrepreneurs and investors in small businesses, Section 1202 of the tax code allows for the exclusion of up to 100% of capital gains on the sale of Qualified Small Business Stock (QSBS), provided the stock is held for more than five years.
• Key benefits: The exclusion can apply to up to $10 million of gains or 10 times the taxpayer’s basis in the stock, whichever is greater. This can be a powerful tax-saving tool for founders, investors, and early employees of startups.
9. Estate Planning: Stepped-Up Basis
When an individual passes away, their heirs receive a stepped-up basis in inherited assets, meaning the asset’s basis is adjusted to its fair market value at the time of death. This allows heirs to sell the asset without incurring capital gains on the appreciation that occurred during the decedent’s lifetime.
• Application for individuals: For those with significant assets, holding appreciated assets until death can provide substantial tax benefits to heirs.
• Application for businesses: Owners of family businesses can use the stepped-up basis to pass the business to heirs without saddling them with significant capital gains tax liabilities.
Conclusion
Effectively managing capital gains tax liability is essential for both individuals and businesses. Whether you’re an individual investor or a business owner, these strategies provide a range of options to reduce or defer capital gains taxes. From long-term holding periods and tax-deferred exchanges to charitable contributions and estate planning, each method requires careful planning to ensure compliance with tax laws while maximizing savings. Consult with tax professionals and financial advisors to tailor these strategies to your specific situation and take full advantage of available tax-saving opportunities.
