What are capital gains?
Let’s start at the beginning. According to the IRS, “[a]lmost everything you own and use for personal or investment purposes is a capital asset.” When you sell a capital asset for “more than its adjusted basis,” this creates a capital gain. When you sell it for less, it creates a capital loss.
The “adjusted basis” of a capital asset is usually the amount you paid for the asset, net of transaction fees, but the exact calculation depends on the asset and circumstances.
For purposes of publicly traded securities like stocks or funds, your adjusted basis is generally what you paid for the shares after taking into consideration distributions to shareholders like dividends. Brokerage firms typically keep track of the adjusted basis of each position within your account and make this information easily accessible.
Unrealized gains/losses represent the gains/losses that an investment would generate if you were to sell it at prevailing market prices. Realized gains/losses represent the gains/losses that have already occurred.
Brokerage firms keep continuous track of clients’ realized and unrealized capital gains and losses and provide final statements at year end. These calculations are included on Form 1099, which also contains important information about interest, dividends and other distributions.
What are capital gains taxes?
Based on transaction activity that occurs over the course of the year, realized capital gains or losses could affect one’s overall tax liability (for federal and potentially state taxes as well).
To make matters more complicated, tax rates and applicable brackets on realized capital gains vary significantly and can change over time. They are also connected to one’s overall income tax bracket, which is affected by other sources of income.
For most taxpayers, capital gains tax rates are generally lower than ordinary income tax rates (in order to encourage investment). For example, if your status as a taxpayer is “married filing jointly” and your overall taxable income is less than $89,250, your capital gains tax rate is currently 0%. (The tax rate initially increases to 15% above that cut-off.)
Individuals living in states with no personal income taxes may incur no state level tax liability related to realized capital gains, while individuals living in states with income taxes could face material tax liability. The rules and applicable tax rates vary by state.
Capital gains taxes are not calculated and paid separately but are integrated into the process of figuring one’s overall tax liability based on all sources of taxable income. For this reason, investors may not always appreciate the extent to which capital gains are impacting their total taxes.
Key concepts
Without getting into too many intricacies, there are some key concepts that individuals should be aware of as they contemplate potential cap gain tax consequences from investments they have made or are considering making.
(1) Gains and losses offset
A taxpayer’s overall capital gain tax liability is based on an aggregated calculation of potentially many transactions, which can offset. For example, if an investor realized a $2,000 gain in one stock but generated an $800 loss in another stock, the net taxable gain would be $1,200.
(2) Short-term versus long-term
The tax code has historically drawn a distinction between long-term and short-term capital gains (in order to encourage long-term investment). The cut-off between short-term and long-term is one year. Short-term gains are generally treated as ordinary income and therefore subjected to higher rates. It may seem odd, but a gain that is realized after 364 days could be taxed much more punitively than one realized after 365 days.
(3) Losses carryforward
Another key principle investors should understand is that unused capital losses can “carryforward” from one year to the next. Taxpayers must keep track of what this carryforward amount is at the end of the tax year and can then use it in the subsequent year to shield potential gains. The carryforward amount is then recalculated at the end of that year and, if still negative, can be applied to the following year.
Strategies to minimize cap gains taxes
While these details can seem overwhelming, having a working knowledge of the mechanics of cap gains is critical. Potential capital gains implications deserve consideration whenever an investor is thinking about making a move. There are also steps one can take to try to minimize cap gains taxes without drastically altering the portfolio.
(1) Avoid selling, especially within one year
For many reasons, we recommend a long-term approach to investing, which means prioritizing investment opportunities that will work over the long term. Capital gains tax liability is one of several good reasons to seek investments that can be expected to deliver strong returns year after year, without the need to liquidate the investment in a short time frame.
Warren Buffett famously contrasts high quality stocks that compound your wealth over time, “compounders,” with what he calls “cigar butts.” A cigar butt (you take one or two puffs and it’s done) is typically a mediocre company that is temporarily undervalued for one reason or another.
Cigar butts may present a good opportunity to make a relatively quick 20% or 30% gain but are not necessarily securities you might be interested in having exposure to over the long haul. They are just mispriced at the moment. The goal is to play an anticipated correction in the price.
Capital gains taxes are one of the drawbacks of investing in cigar butts as opposed to long-term compounders. There is always the risk that the business you perceive as undervalued actually is damaged goods—the notorious “value trap.” But even if the investment works, you may have to share a large portion of the upside with your friends in the government.
Many short-term trading opportunities tend to play out within 12 months. Depending on what state you live in, your tax bracket and other factors, having to pay taxes at ordinary income tax rates on a successful short-term investment is generally much less attractive than having to pay no taxes on a long-term investment that has appreciated and may continue to do so for years to come.
Perhaps the best strategy for minimizing tax burdens is to prioritize investment opportunities that you can see yourself owning almost indefinitely. These could include efficient, low cost index funds or ETFs that generate minimal capital gain distributions. These opportunities may also be high quality stocks (like the ones we target in our Model Portfolios) that are reliable long-term value creators.
(2) Use tax-sheltered accounts
Investments held in Individual Retirement Accounts (IRAs) or similar tax-sheltered accounts are generally not impacted by capital gains considerations. For this reason, investors may consider these types of accounts to place investments that could be expected to generate capital gain realizations, especially if they are short-term.
(3) Harvest losses
Realizing capital losses as they occur allows investors to offset gains in any particular year or build a reserve for future years. There are two major challenges associated with harvesting losses.
First, one does not necessarily want to sell an investment simply because it has gone down. It may even become a more attractive investment at the lower price point.
Second, there is the “wash sale rule,” with which all investors should be familiar. There are some wrinkles to it, but the general idea is that investors cannot purchase the same or a “substantially identical” security within 30 days of the sale (before or after). If they do, the capital loss is “washed” and cannot be realized until the second purchase is reversed.
So how can an investor try to crystalize capital losses without exiting the position for at least 30 days?
In the context of funds or ETFs, a brokerage firm will automatically identify a wash sale event if you repurchase the exact same security within 30 days. By rotating into a similar but not substantially identical fund or ETF, this problem can be avoided. We encourage investors interested in this strategy to investigate what the IRS considers “substantially identical.” There is no precise definition.
In the context of crystalizing losses in individual stocks, one tactic is to purchase the same number of shares of the same stock that you ultimately intend to sell for a loss. After 30 days, you can sell the first “lot” of shares (the originally purchased shares) while holding onto the second lot. The end result is you maintain the same position in the stock but have realized a capital loss.
To execute this strategy successfully, investors needs to specify which lot (the one with the higher cost basis) they intend to sell within their brokerage accounts. Investors also need to have enough confidence in the stock to have increased exposure to it for a 30+ day period. An investor is effectively doubling down on the stock with this approach, if only for a few weeks, so it is not without risk.
Harvesting losses is smart, but one does not necessarily want to exit positions just because they have declined in price. The advanced strategies mentioned above are effective but need to be executed carefully with a clear understanding of the rules. To reduce complexity, we would suggest deploying these techniques only when substantial losses become available (such as a severe market or share price correction).
(4) Offset ordinary income
Capital losses up to $3,000 per year ($1,500 married filing separately) can be applied as a reduction of ordinary taxable income. This represents a good incentive to generate at least some losses if possible. Capital loss carryforwards can be used as offsets to ordinary income in future years, up to the allowable limit.
Unfortunately for investors, the $3,000 offset was established in 1976 and has never been increased for inflation. To adjust for inflation, the limit would have to be raised to more than $15,000 today.
(5) Beware of funds with embedded unrealized gains
Actively managed mutual funds have a lot of flaws as we described in our Guide to Independent Investing. One of them is the way in which they account for capital gains.
Mature mutual funds often build up large embedded unrealized gains in long-term holdings. When these positions are sold, they generate capital gains that are distributed to all shareholders, even brand new ones. So when you invest in an actively managed mutual fund, you are sometimes buying into cap gains liabilities produced by earlier investors in the fund.
This unattractive feature of mutual funds can become a big problem when a particular mutual fund experiences investor redemptions, which often happens in down markets. The fund managers then have to sell down their position in stocks with large unrealized gains, which causes the annual cap gain distribution to grow. Meanwhile, because investors are redeeming, there are fewer shareholders left to receive this distribution.
Investors in active funds sometimes find themselves in the unfortunate position of receiving an annual capital gain distribution, on which they must pay taxes, even if they have not made any money in the fund. This is a problem that is basically unique to actively managed mutual funds and can be avoided by using passive funds or ETFs as well as direct stock ownership.
(6) Time the realization of gains appropriately
As noted, under current rules, if your total income is below a certain threshold, cap gains realizations may generate no taxable income at all. Personal circumstances can vary from year to year. Investors may choose to take advantage of a low income year to realize gains in taxable accounts so as to avoid potentially taxable realizations in future years.
The idea here is essentially the inverse of tax loss harvesting. One can deliberately realize gains to establish a higher basis in the investment, which will translate into potentially lower tax liability down the road.
Wash sale rules are not relevant in this scenario since one is creating a gain rather than a loss. If you believe you will not be subject to capital gains taxes in a certain year, you can sell the investment that has the gain and immediately repurchase it.
(7) Do not overemphasize capital gains
Being mindful of taxes is very important, but there is a risk of investors getting too carried away with the objective. This could lead to investors refusing to sell positions they otherwise would and should sell but for the potential tax implications.
One advantage of harvesting losses and accumulating carryforwards is that it can provide a “strategic reserve” of losses that gives an investor room to realize gains from time to time. In this context, investors should be mindful as well that when companies they own get acquired, they are often forced to liquidate, creating a potential cap gain liability.
Because you never know when you might want to or be forced to realize a gain, it is always nice to have a cushion of losses.
Why defer gains?
Paying taxes on capital gains is undesirable because it forces an investor to part with capital that can otherwise be put to productive use. Capital gains cannot be eliminated but can be deferred. By delaying these cash payments, the money can continue to compound.
Capital gains may ultimately have to be realized but the idea is to have as much control over the timing as possible. A major turning point could be retirement, when other sources of income largely disappear and an individual drops into a lower tax bracket.
There is also the unfortunate reality that one can experience investment losses in the future, either because of a market downturn or an investment mistake. By deferring and accumulating gains, one is preserving the possibility of benefiting from potential future losses.
Unfortunately, one cannot use future losses to recover capital gains tax payments that have already been made. So it is arguably always best to push capital gains realizations into the future.
If you are fortunate enough to be in a position to pass your investment portfolio onto your children or other heirs, the “stepped-up basis” rule means that the basis of inherited property gets increased to prevailing market levels when it is transferred. The upshot is capital gains taxes never have to be paid in this scenario (although estate taxes may apply).
The Democrats did recently attempt to apply a limit to the value of assets that are protected by the stepped-up basis rule, but it remains in effect. Over time, this particular rule (and all tax policies for that matter) can evolve, but with Trump entering the White House, it will very likely be preserved for the foreseeable future.
Staying motivated
We recognize that any discussion of the extraordinarily convoluted U.S. tax code can cause one’s eyes to glaze over. This is perhaps deliberate. The less you know, or can bear to learn, the more you pay.
Understanding how your investments interact with the tax code is annoying, which raises the risk that your mind will move on to more pleasant or interesting subjects. Yet the consequences of ignorance here are substantial.
So how can one stay focused on this important topic? Perhaps it makes sense to remember—this is a zero sum game. Your portfolio consists of money that you worked hard for, didn’t spend (either on yourself or your family members), and then put at risk in a way that helped the economy grow.
When your investments succeed, they want to take some of this success from you. And for what purpose? To pay for what? From their perspective, the more money you part with, because you didn’t fully understand your options, the better.
Don’t let them break your spirit with a bunch of boring rules. This is your money, your future and your family’s future! Take the time to understand how the system works. Fight for it!
