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.
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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.