Under current law, higher-income taxpayers will face a 3.8%surtax on their investment income and gains. Additionally, if the EGTRRA and JGTRRA sunsets go into effect, all taxpayers will face higher taxes on investment income and gains, and the vast majority of taxpayers also will face higher rates on their ordinary income. This third part of a multi-part year-end planning article explains how the careful handling of capital gains and losses by individuals can save taxes
The case for selling appreciated assets this year. An individual taxpayer who is considering selling some appreciated assets, e.g., because he believes the assets are close to their peak price, or because he needs funds to make other investments that he believes will be even more profitable, should consider the extent to which he should sell all or part of those assets in 2012. While it is often better to defer receipt of income (including capital gains) so as to also defer the payment of tax, for the following reasons it maybe better to sell appreciated assets this year.
(1) This year's maximum long-capital gain rate may be lower than next year's maximum rate. For 2012, long-term capital gains are taxed at a maximum rate of 15% (0% to the extent the gain would otherwise be taxed at a rate below 25% if it were ordinary income). By contrast, if the EGTRRA/JGTRRA sunset takes effect, in 2013 long-term capital gain will taxed at a maximum rate of 20% (18% for assets held more than five years). For lower-income taxpayers, the maximum rate will be 10% (8% for assets held for more than five years).
(2) Capital gains of some high-income taxpayers may be subject to a 3.8% surtax in 2013.
(3) Even if the 2012 long-term capital gain rates are extended so that they still apply in 2013, some taxpayers may be in a lower tax-bracket this year than they will be in next year so that all or part of their long-term capital gain may be subject to no tax (or lower tax) if taken into account this year.
(4) Some individuals may be able to make better use of capital losses this year, e.g., be able to offset short-term capital gains with long-term capital losses.
When to sell appreciated assets is not just a tax issue. Most planning involving capital gains and losses requires consideration of investment factors as well. For example, a taxpayer won't want to defer recognizing gain until the following year if there's too much risk that the value of the property will decline before it can be sold. Similarly, a taxpayer won't want to risk increasing a loss on property that he expects will continue to decline in value by deferring the sale of that property until the following year.
Avoiding higher potential rates on long-term capital gains in 2012.Some individuals may have gains on stocks, bonds, mutual fund shares, or other investment assets that they are planning to sell in the next few months to raise funds for other purposes, or because they believe some investments are unlikely to go much higher or may even start declining in value. By selling these assets before the end of the year, these individuals would be sure to benefit from the lower maximum long-term capital gain rate that is in effect in 2012 but which may not be in effect in 2013.
At this time, it's uncertain whether the EGTRRA/JGTRRA sunset will take effect to increase the maximum tax rate on long-term capital gains, will rise only for higher income taxpayers, or will be deferred once again. Since it's possible that the matter will be resolved before the end of the year by the lame duck Congress, an individual who wants to make a sale this year only if the rate does go up next year should wait—with due regard for the investment factors—to nearer the end of the year to see what happens.
Effect of 3.8% surtax on when to take capital gains into account.For tax years beginning after 2012, a 3.8% surtax applies on the lesser of (i)net investment income or (ii) the amount by which modified adjusted gross income(MAGI) exceeds a threshold amount. The threshold is $250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case. MAGI is adjusted gross income increased by the amount excluded from income as foreign earned income under Code Sec. 911(a)(1) (net of the deductions and exclusions disallowed with respect to the foreign earned income). Net investment income generally includes items such as taxable interest, dividends, annuities, and capital gains.
Individuals who otherwise plan to sell appreciated assets in the next few months, and who would be subject to the surtax, should consider making the sale this year to avoid the surtax. Delaying the sale until next year would result in an increase in taxes even if the EGTRRA/JGTRRA sunset does not go into effect. If the sunset does go into effect, it will result in an even higher increase in the excess of the tax that would have to be paid on their gains in 2013 over what they would have to pay in 2012.
Cut taxes on some long-term capital gains by taking the min 2012, even if EGTRRA/JGTRRA sunset does not come into effect in 2013. Even if the EGTRRA/JGTRRA sunset does not come into effect in 2013, some comparatively lower-income taxpayers may be able to reduce their taxes on long-term capital gains by taking those capital gains in 2012 instead of 2013, or by splitting gains they plan to take between 2012 and 2013. Taking some of those gains in 2012 may be especially useful for taxpayers who expect to have substantially lower taxable income other than long-term capital gains in 2012 than in 2013, e.g.,because they have been out of work for a good part of 2012 but expect to be employed for all or most of 2013.
Using available losses. Long-term capital losses are used to offset long-term capital gains before they are used to offset short-term capital gains. Similarly, short-term capital losses must be used to offset short-term capital gains before they are used to offset long-term capital gains.Noncorporate taxpayers may use up to $3,000 of total capital losses in excess of total capital gains as a deduction against ordinary income in computing AGI.
For 2012, a noncorporate taxpayer is subject to tax at a rate as high as 35% on short-term capital gains and ordinary income. If the EGTRRA/JGTRRA sunsets take effect, for 2013, a noncorporate taxpayer will be subject to tax at a rate as high as 39.6% on short-term capital gains and ordinary income. As noted above, in 2012, most long-term capital gains are taxed at a maximum rate of 15%, but will be taxed at a maximum rate of 20% in 2013 if the EGTRRA/JGTRRA sunsets take effect (18% for assets held more than five years).
A taxpayer should try to avoid having long-term capital losses offset long-term capital gains since those losses will be more valuable if they are used to offset short-term capital gains or ordinary income. Thus, to the extent that taking long-term capital losses in a different year than long-term capital gains is consistent with good investment planning, the taxpayer should take steps to prevent those losses from offsetting those gains.
How to preserve investment position after recognizing gain or loss on stock. For the reasons outlined above, paper losses or gains on stocks may be worth realizing in 2012 to recognize losses and use them to offset other gains, or to avoid potentially higher taxes if appreciated stocks are sold in 2013 or a later year. But suppose the taxpayer owns stock that is an attractive investment worth holding onto for the long term. There is no way to precisely preserve a stock investment position while at the same time gaining the benefit of the tax loss, because the so-called “wash sale” rule precludes recognition of loss where substantially identical securities are bought and sold within a 61-day period (30 days before or 30 days after the date of sale). Thus, a taxpayer can't sell the stock to establish the tax loss and simply buy it back the next day.
The wash sale rules apply only when securities are sold at a loss. As a result, a taxpayer may recognize a paper gain on stock in 2012 for year-end planning purposes and then buy it back at any time without having to worry about the wash sale rules.