The timing of capital gains and losses may have a significant impact on your tax bill. So it pays to consider the tax implications before you sell investments, particularly as the end of the year approaches.
The Long and short of it
Generally, the longer you hold an appreciated investment, the better. It allows you to defer taxes, which maximizes growth and may reduce the tax if you are in a lower tax bracket when you sell. Additionally, holding an investment for more than a year allows you to take advantage of lower long-term capital gains tax rates.
Short-term gains — assets held for one year or less — are taxed at ordinary-income rates, which could be as high as 37%, depending on income level. If you hold an asset for more than a year, you will qualify for favorable long-term capital gains rates. Depending on your income level, the preferential rate could be 15% or 20% (plus 3.8% net investment income tax, if applicable).
When sooner is better
If you plan to sell an investment at a loss, it may be advantageous to do so before you reach the one-year mark. That is because, to determine your net capital gain or loss in a given year, you begin by offsetting gains and losses of the same type (long- and short-term investments).
Say, for example, that you have already recognized $10,000 in short-term capital gain and $10,000 in long-term capital gain this year. You also own a stock, purchased just over 11 months ago, that has declined in value by $10,000. If you sell the stock now, you will have a $10,000 short-term loss that offsets your $10,000 short-term gain. This leaves you with a $10,000 long-term gain taxed at a favorable rate. But, if you wait a month until you have held the stock for more than a year, the long-term loss must be used to offset the long-term gain, leaving you with a $10,000 short-term gain taxed at the higher ordinary rate.
Strategic gains and losses
You need to think strategically when taking capital gains and losses. If you plan to sell investments that will generate both capital gains and losses, doing so in the same year allows you to offset losses against gains and reduce your tax bill. In some cases, however, it may make sense to postpone gain until the following year.
Taxpayers are permitted to deduct up to $3,000 in capital loss from their salary or other ordinary income. Suppose you have a $3,000 net capital loss in 2019. You also own a stock whose sale would yield a $3,000 long-term capital gain. If you wait until 2020 to sell it, the gain will be taxed at favorable long-term rates and you will be able to deduct this year’s $3,000 loss from your ordinary income. But if you sell the stock this year, the gain will offset the capital loss and you will not be able to use it to offset ordinary income.
Taxes are not everything
Keep in mind that tax considerations alone should not control your investment decisions. However, understanding the tax consequences of various investment strategies can help boost your portfolio’s returns.
For more information, contact Adam M. Levine at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Services.