UPDATE: It sounds like the compromise reached this week on extending tax cuts will also extend the very favorable treatment of long-term capital gains. So, assuming the legislation actually gets passed by year-end, you can put the advice in this article on hold for another year or two…although if you’re in a much lower tax bracket this year than you expect to be in the next few years, you still may want to consider the moves suggested below. And increasing your basis in stocks at no cost is never a bad idea.
As we approach the end of 2010, a possibly-once-in-a-lifetime opportunity may be coming to an end.* Taxpayers who fall in the 10% or 15% tax brackets are able to recognize gains on the sale of capital assets (generally stocks, bonds, real estate, etc.) and pay 0% tax on the gain as long as you’ve held the assets long-term (i.e. more than a year). Yeah, 0, as in nothing. Generally if you’re single with taxable income of $34k or less or married filing jointly with taxable income of $68k or less, then you’re in the 10% or 15% bracket. (NOTE: Taxable income means after subtracting deductions, so your actual income may be much higher.) And for those with significantly higher incomes, you currently enjoy 15% capital gains rates which is near an historic low. After 2010, these rates are scheduled to go back up unless the government acts to change the laws enacted by previous administrations.
So here’s one great strategy, especially for those who can recognize gains at the 0% rate: sell stocks that have gone up in value, then immediately buy them back. Why would you do this? To save several thousand dollars potentially. Here’s how: by selling the stock now (and immediately re-buying the stock), you increase the basis at no actual cost to you. Basis is how you determine how much gain you have from a stock, and therefore how much tax you have to pay, and the more basis you have, the better off you are. Here’s an example:
Let’s say a couple has $40k in taxable income. (To give a fuller picture, we’ll say they actually have a household income of $70k, but between their deductions and exemptions for themselves and dependents, their taxable income is only $40k.) Suppose that couple has invested $25k in stocks over the last couple decades, and those stocks are now worth $50k. But if they sell the stocks at the current value of $50k, recognize the gain of $25k, then re-buy the stock at $50k, they’ve increased their basis (or investment) in the stock from $25k to $50k. The additional $25k of income gets $0 tax because their taxable income (even after adding the gain from stock sale) is still in the 15% bracket. To see the real value in this strategy, let’s see what happens in 2011…
…Imagine in 2011 the higher-earning spouse is laid off, and to cover expenses the couple decides to sell the stock. If the stock is still worth $50k, and they sold-and-repurchased the stock in 2010, they will recognize no gain (i.e. no income) from the sale and have no tax to pay. BUT, if they did NOT sell-and-repurchase the stock in 2010, then when they sell the stock in 2011 they will recognize a long-term gain of $25,000. Based on the law as currently written, they will have to pay a 10% tax on the $25k gain, or $2,500. So in this simple example, the couple saves $2,500 from this very simple strategy.
It’s also possible that this couple will hold the stock for many years, during which time their income and personal tax bracket may rise, or tax rates in general may rise, or both. Regardless of what happens, the $25k in increased basis represents $25k that will never be taxed in the future (barring a complete legal overhaul of the nature of income tax in this country…which would be an event nobody can plan for anyways).
In general, if you’re in the 10% or 15% tax bracket, and have appreciated assets that can easily be sold and replaced (e.g. stocks and bonds), then you should strongly consider selling these assets and repurchasing them by year-end. This strategy may also make sense for upper income taxpayers as well, if they expect to sell assets in the next few years anyway, and do not anticipate their income going down substantially.
Of course, it’s always a good idea to review your specific situation with a tax professional before taking action. This advice cannot possibly take into account every variable that could affect your tax situation. I will point out one useful tool you can use, if you’re reasonably familiar with your own tax situation, is TaxCaster from TurboTax. Here you can enter all of your current information (income, deductions, marital status, dependents, etc.) and get a very good estimate of what your tax liability will be. Then go to the “Other Income” category of the app and in the “Gains/Losses (long-term)” category you can enter the gain you would recognize by selling appreciated stock you own. TaxCaster will immediately recalculate your tax liability with this new information. If your “Total Income” changes, but not “Your Refund”, this means you will likely not pay any additional tax by selling that stock. You can effectively increase your basis in the stock at no cost, potentially saving you thousands of dollars in taxes down the road.
A couple final NOTES: If your stocks pay large dividends, and the gain relative to the total value of the stocks is small, then this strategy also might not make as much sense. The reason is that by repurchasing the stock, you’ll lose preferential “qualified dividend” treatment on the stock for a year. In most cases, this effect will be very small relative to the basis increase that you gain. But in rare cases–with large dividends and relatively small built-in gains–the effect of losing qualified dividend status for a year might offset the gains from increasing your basis. ALSO, this analysis does not consider the impact of state taxes. States generally offer no special benefit for long-term capital gains, so you’ll likely recognize income at your regular state rates.
*Of course, the political process is unpredictable and I make no claims on psychic powers.