Monthly Archives: November 2018

Tax Gain Harvesting

Last week’s post addressed the concept of tax loss harvesting – selling stock or securities (in a taxable account) to create a beneficial tax loss. This post addresses tax gain harvesting – selling stock or securities (in a taxable account) to create a beneficial tax gain.

Beneficial tax gain? How could it be good to create a taxable gain?

Fortunately, not all taxable gains create federal income tax. Below I discuss two scenarios where incurring a taxable gain may not increase a taxpayer’s current tax liability and would have other favorable consequences.

0% Capital Gains Tax

Under current law, some taxpayers pay a 0% federal income tax rate on long-term capital gains. Based on the new tax numbers effective after tax reform, more and more taxpayers will find themselves in relatively low marginal tax brackets.

Single taxpayers with a taxable income of $39,475 or less and married filing joint (“MFJ”) taxpayers with a taxable income of $78,950 are currently (using 2019 numbers) subject to a 0 percent federal long-term capital gains tax rate. Because the calculation is based on taxable income and not adjusted gross income, taxpayers get the benefit of the standard deduction (or itemized deductions, if greater). Thus, single taxpayers with adjusted gross income of $51,675 (including a standard deduction of $12,200) or less and MFJ taxpayers with an adjusted gross income of $103,350 (including the $24,400 standard deduction) or less qualify for the 0% federal capital gains.

This presents a great planning opportunity if the taxpayer has an appreciated security (such as a stock, bond, mutual fund, or ETF). Here is an illustrative example:

Example 1: Joe and Mary file their 2019 tax return MFJ. In 2019 Joe and Mary will together have $81,000 of W-2 wages. They have $1,000 of interest and dividends. They take the standard deduction (which is $24,400 for MFJ in 2019). Thus, their 2019 taxable income is $57,600 ($81,000 plus $1,000 less $24,400). Assume Joe and Mary own 100 shares of Acme Corp., which they purchased five years ago for $10 per share ($1,000 total). Assume further that the stock is worth $11,000 on December 1, 2019. Joe and Mary could sell the stock on December 1st, realize a taxable gain of $10,000 ($11,000 less $1,000 cost basis), thus increasing their taxable income to $67,600.

Since their taxable income is still $78,950 or less, the entire $10,000 capital gain is subject to the 0 percent federal capital gains tax. This result obtains regardless of whether Joe and Mary purchase 100 Acme shares two days later for $11,000. Unlike tax loss harvesting, which is subject to the wash sale rules, there are no wash sale rules as applied to taxable gains.

Why might Joe and Mary sell at a tax-free gain and then repurchase? While they don’t pay tax, they don’t save on their 2019 taxes. However, the sale/repurchase significantly increases their tax basis and decreases the taxable gain they will have on a future sale of Acme stock. There’s no way to know if a future sale of Acme stock will be subject to a 0 percent federal capital gains tax rate. By tax gain harvesting, Joe and Mary have dramatically increased their basis in the Acme stock from $1,000 to $11,000 tax-free. Thus, a future taxable sale will incur much less tax.

If, alternatively, Joe and Mary decide that they want to exit their Acme stock holding (thinking that perhaps its meteoric rise has concluded), tax gain harvesting provides them with a tax-free exit. Tax gain harvesting, if you qualify for a 0 percent capital gains tax rate, provides a way to reallocate your portfolio’s holdings without paying federal capital gains tax on appreciated holdings.

Caveats

Three caveats about tax gain harvesting are worth mentioning. First, the determination of whether your taxable income is low enough to qualify for the 0 percent capital gains rate includes the gain itself. Referencing Joe and Mary, if instead of $81,000 of W-2 wages, they had $100,000 of W-2 wages, their tax gain harvesting opportunity is dramatically decreased. In this case, their taxable income before the gain ($76,700 – computed as $100,000 plus $1,000 less $24,400)) appears to qualify for the 0 percent capital gains rate, once you add the $10,000 gain, the taxable income is $86,600, and the gain no longer qualifies for the 0 percent capital gains tax rate.

Second, the gain causes your “adjusted gross income” and “modified adjusted gross income” to increase, and thus have negative consequences on other preferential tax items, including deductions, credits, and qualifying for certain tax benefits. In some cases it may be worth it to run the numbers through a tax forecasting program and/or consult with a professional advisor before pulling the trigger to help understand the impacts on other parts of your tax picture.

Third, state income taxes must always be considered when tax gain harvesting. There are some states that impose no income tax, and thus there’s no problem. But in most states there is an income tax, and there’s no preferential rate for capital gains. States generally tax capital gains like any other type of income. Thus, there can be a (usually small) state income tax on capital gains triggered through tax gain harvesting.

Depending on the state, the tax rate on the harvested gain might be small enough to make tax gain harvesting still well worth it. In any event, it is always advisable to consider what the state income tax effects of potential tax gain harvesting will be before pulling the trigger.

Offsetting Losses

Another time it may be worth it to tax gain harvest is when you already have incurred a significant taxable loss during the taxable year. Here is an illustrative example:

Example 2: In March 2019, Eileen sold shares of the XYZ Mutual Fund and realized a $13,000 capital loss. She has no other capital gains or losses in 2019. If she does nothing else, she will be able to deduct $3,000 of the loss against her ordinary income and carryforward $10,000 of the capital loss to 2019. If Eileen owns shares in the ABC Mutual Fund with a $10,000 built-in gain, she could sell those shares in December 2019, incur no marginal federal or state income tax, and still claim a $3,000 capital loss on her 2019 federal income tax return.

Eileen is now positioned to realize the benefits of tax gain harvesting. She can either restructure her portfolio in 2019 with no additional tax cost on the ABC Mutual Fund gain, or can repurchase ABC Mutual Fund shares shortly after the sale and increase her basis by $10,000.

It is worthwhile to note that by tax gain harvesting here, Eileen does cost herself in tax in the future, since she won’t have the $10,000 capital loss carryforward to use to offset future capital gains (and up to $3,000 in ordinary income) in 2020 and beyond. Thus, tax gain harvesting to offset current year capital losses involves tradeoffs, and taxpayers considering it are often well advised to run the numbers through a tax forecasting program and/or consult with a professional advisor before pulling the trigger.

Conclusion

Those with appreciated assets in taxable accounts should consider tax gain harvesting. One or both of the following need to be true: the taxpayer is in a relatively low tax bracket or has a capital loss in the current taxable year. If either or both are true, there may be an opportunity to save on future capital gains taxes and/or restructure a portfolio at no or low tax cost. As always, it is best to run the numbers and/or consult with a professional advisor before pulling the trigger.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Tax Loss Harvesting

If you have individual stocks or other securities that have a loss in them, you may have a tax planning opportunity: tax loss harvesting.

First off, it is important to keep in mind that tax loss harvesting only applies to assets (such as stocks, bonds, mutual funds, ETFs, etc.) in taxable accounts. It does not apply to assets in retirement accounts and health savings accounts.

If you have assets in taxable accounts that have declined in value relative to your purchase price, you have an opportunity to tax loss harvest. Here’s a basic example:

Example 1: Mark purchased 100 shares of Kramerica stock two years ago for $100 a share ($10,000 total). Based on a disappointing test of an oil-tanker bladder system, Kramerica’s stock is now worth $70 per share. If Mark sells all 100 shares for $70, his total basis in the stock ($10,000) exceeds the amount he realizes on the sale ($7,000) by $3,000.

In Mark’s case, he has a $3,000 capital loss for tax purposes. Capital gains and losses from the sale of property (for most individuals, from securities) are different for tax purposes than other types of income, such as wages, rents, self-employment income, interest, and dividends (collectively, usually referred to as “ordinary income”). Federal income tax law does two things to capital gains and losses. First, it taxes capital gains at a lower tax rate than most other types of income. Second, and most importantly for the purposes of tax loss harvesting, it limits the ability of a capital loss to offset ordinary income.

Capital losses, such as Mark’s loss on Kramerica stock, can offset either capital gains or ordinary income, but only to the extent of $3,000 ($1,500 if the taxpayer files married filing separate) of ordinary income a year.

Thus, tax loss harvesting is a great play in two situations:

  1. A taxpayer has a large capital gain in a taxable year; and,
  2. A taxpayer has ordinary income and can trigger a $3,000 capital loss.

A second example can illustrate the first situation.

Example 2: Lucy sells stock with a historic cost basis of $30,000 for $50,000 in March. Thus, she will have to report a $20,000 capital gain on her tax return. If, however, Lucy has another stock/bond/mutual fund/ETF with a historic cost of $100,000 and a fair market value of $80,000, and she sells it by year-end, she will harvest the $20,000 loss in time to offset the previous $20,000 gain.

Taxpayers with significant capital gains during a year should review their taxable accounts towards year-end to see if there are any opportunities to harvest losses and offset existing capital gains.

For those taxpayers without capital gains, there still can be some opportunity to tax loss harvest.

Example 3: Edward anticipates making approximately $100,000 in 2021 in wages from his employer. If Edward can identify a stock/bond/mutual-fund/ETF with a built-in loss, he can sell the security and reduce his taxable income up to the lesser of the loss or $3,000 in 2021. If Edward owns the XYZ mutual fund with a historic basis of $5,000 and a current value of $2,000, he can sell it before year-end and reduce his taxable ordinary income from approximately $100,000 to approximately $97,000. The capital loss deduction is one taken on the first page of the Form 1040 and is not an “itemized deduction.” Thus, Edward gets the deduction regardless of whether he itemizes his deductions.

Note that Edward is limited in his ability to deduct capital losses in any one taxable year to $3,000. Let’s slightly revise the previous example.

Example 3A: The facts are the same as in Example 3, except the the stock Edward sells has a basis of $10,000. Thus, Edward’s current year capital loss is $8,000 ($10,000 basis less $2,000 sales price) instead of $3,000. However, Edward still can only deduct $3,000 because of the limit on taking capital losses against ordinary income. Thus, Edward’s 2021 taxable income is still approximately $97,000.

Edward can carry forward the excess unused capital loss ($5,000, which is the $8,000 actual loss less the $3,000 used loss) into future tax years. Thus, in 2022, he can offset capital gains and up to $3,000 of ordinary income by the $5,000 capital loss carried forward. If Edward has no capital gains or losses in 2022, he can deduct $3,000 of the $5,000 against his 2022 ordinary income, and then carryforward a $2,000 capital loss into 2023. Edward carries forward the capital loss until it is fully used.

Wash Sales

Tax loss harvesting sounds great, right? But with tax, there’s almost always a catch, and one exists here. The so-called “wash sale” rules.

They are best understood by understanding the concern they address. Say in our first Example Mark sells his 100 shares of Kramerica stock on December 15th to trigger the capital loss. Then on December 16th Mark buys 100 shares of Kramerica stock. Absent the wash sale rules, Mark has had no change in his overall economic position (he still owns 100 shares of Kramerica) yet he’s realized a $3,000 capital loss for tax purposes.

The wash sale rules step in to prevent this sort of gamesmanship. They disallow any loss on the sale of securities when the taxpayer buys the same or similar securities within the period starting 30 days before the loss sale and going through 30 days after the loss sale. The rule applies broadly. It applies to similar securities — for example, selling Vanguard’s S&P 500 index mutual fund at a loss and buying Fidelity’s S&P 500 index mutual fund. It applies to purchases of the same or similar securities by the taxpayer, the taxpayer’s spouse, and by entities controlled by the taxpayer and the taxpayer’s spouse. It can also potentially apply to purchases inside retirement accounts. The wash sale rule also bites to the extent of shares purchased through a dividend reinvestment program where the reinvestment occurs within the 61 day window described above.

Conclusion

Tax loss harvesting provides taxpayers a great opportunity to offset capital gains and possibly up to $3,000 of ordinary income. To work effectively for 2021, taxpayers must sell loss securities by December 31st and must be careful to avoid repurchasing the same or similar securities in a manner that triggers the wash sale rules and disallows the capital loss.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.