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Alan Haft
 

Minimizing Capital Gains Taxes

Six tips show you how.

March 21, 2011
by Alan Haft

March is one of my favorite months of the year. Winter’s just about over, NCAA March Madness is around the corner, the NBA the playoffs are coming up, flowers are getting ready to bloom and topping the list is the fact that most of us get to spend time preparing to pay taxes.

How great is that?

Although I’m certain the government is going to put our tax payments to good use, I prefer to minimize the amount I pay and that’s why I pay attention to how I might lower them, especially on things such as capital gains.

Capital gains are certainly nothing new to CPAs but to many clients, capital-gains distributions remain one of the great mysteries of accounting. For this reason I thought a quick column on what they are and how to potentially reduce them could be of some help.

Capital Gains 101

As an investor, sometimes your clients sell shares of an investment, such as a stock or a mutual fund. When your clients make money on that sale, they realize a capital gain.

But that’s not the only type of capital gain that exists. Each year, a mutual fund must distribute to its shareholders a portion of any net capital gains it earned when it sold securities in its portfolio. (Net capital gains are what remain after capital losses are subtracted from capital gains.) As a shareholder, you must pay taxes on those gains. So, even if your clients didn’t actually sell any of their fund shares, they could end up paying capital-gains taxes.

As unfair as it sounds, this is what I often refer to as the Mutual Fund Twilight Zone Paradox: sometimes funds pay out capital gains distributions in years that they’ve actually lost money. In 2002, for example, the performance of many funds was down. But at the same time, to meet redemption requests, many fund managers were forced to sell profitable growth stocks they’d held during the run-up of the 1990s. As a result, many shareholders were stuck with funds that lost money, yet still owed taxes on capital-gains distributions from the funds.

In addition and unbeknownst to some, “tax free” municipal-bond funds may realize capital-gains tax from selling bonds at a profit, even though the funds are managed for tax-exempt income.

Minimizing Capital Gains — and Taxes

If your clients are unhappy with the amount of taxes they pay, you may want to encourage them to start planning now to ensure that next year they maximize the money that goes into their own pockets and minimize the money that goes into Uncle Sam’s.

Here are some tips that could help:

  1. Minimize your capital gains: This one is simple, my favorite and the one I’d have to say is most often missed. Those planning on selling shares of stock or a mutual fund can potentially reduce their taxable gains by selling shares they bought at the lowest or highest price (which to sell depends on a number of factors too lengthy to explain here).
  2. Make all gains long-term gains: Short-term capital gains are gains from sales of property held one year or less; long-term capital gains are gains from sales of property held for more than one year. In tax year 2010, short-term capital gains are taxed at an investor’s ordinary income rate, which may be as high as 35 percent, depending on your client’s income level. Long-term capital gains, on the other hand, are taxed at a maximum rate of 15 percent: In tax-year 2010, investors in the two lowest tax brackets (10% or 15%) pay zero percent in long-term capital gains tax while everyone else pays 15 percent. So unless your client is in the lowest income tax bracket, they’ll pay lower taxes on capital gains if they hold securities for more than one year.
  3. Use capital losses to offset capital gains: Both long-term and short-term capital losses can be used to offset capital gains on a dollar-for-dollar basis. A taxpayer can carry forward “unused” losses into future years until the losses are deducted, but no more than $3,000 can be deducted in any given year. For example, if an investor has a capital loss of $30,000 and no capital gains, it would take 10 years to deduct that loss ($30,000 ÷ $3,000 = 10 years).
  4. Replacing the losers: If your client takes a taxable loss on a depressed stock or mutual fund and feels it has the potential to rebound, they will want to wait more than 30 days after the date of sale before buying it back. That’s because if they buy identical securities within a period of 30 days before or after the date of sale, the so-called “wash-sale” rule comes into effect. Essentially, the wash-sale rule prevents an investor from claiming a loss on a sale of stock if they buy replacement stock within the 30 days before or after the sale. 
  5. Replacing the winners: The wash-sale rule doesn’t apply when an investor realizes a profit on the sale of a stock or mutual fund: Investors can sell a winner to balance a loss and then buy it back immediately. An added benefit: your clients will also have the added tax bonus of a higher cost basis for their new shares. It might help to explain that cost basis is the original cost of an investment: investors may want their cost basis to be as high as possible because their investment will have appreciated less, and they’ll then likely pay fewer taxes when they sell it.
  6. Not all funds are created equal: Finally, when buying a mutual fund, it could help to encourage your clients to check its tax-efficiency ratio, which is the fund’s tax-adjusted return divided by its pretax return. This is the percentage of total return an investor actually keeps after taxes. The higher the tax-efficiency ratio, the more tax-efficient the fund has been. Tax-efficiency ratios for mutual funds are available on some financial web sites, such as Morningtar.com.

Conclusion

As you can likely tell by now, minimizing capital-gains taxes is not the easiest endeavor but hopefully some of the thoughts above can be of help as you advise your clients this busy season.

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Alan Haft is an investment advisor representative with an insurance license, author of three books including the national bestseller, You Can Never Be Too Rich, and makes frequent appearances in national print, television and radio media such as The Wall Street Journal, Money Magazine, CNBC, BusinessWeek and many others. The amounts represented in this article should all be considered hypothetical and for example only.

For full disclosure, Haft is a part of a firm that utilizes all industries which typically includes us receiving percentage based fees for brokerage services as well as commissions when implementing insurance based plans. Haft does not work for any particular financial company or industry nor should this column be construed as an endorsement or condemnation for any particular product. Readers should note that all views and vendor recommendations as expressed in this article are solely the author’s and do not necessarily reflect the views of the AICPA CPA Insider™ or the AICPA.

This article is not intended to provide tax or legal advice and should not be relied upon as such. Any specific tax or legal questions concerning the matters described in this article should be discussed with your tax or legal advisor