With autumn coming up in a couple months, it’s time to think about “harvesting” capital gains or losses from sales of securities. In addition, unfavorable tax law changes proposed in President Biden’s American Families Plan (AFP) may create an added sense of urgency for some taxpayers.
When you sell securities and other capital assets, the gains and losses are either long-term or short-term, depending on the holding period. To qualify as a long-term gain or loss, you must have owned the securities for longer than one year (absent a special exception). For these purposes, you generally count from the day after the date you acquired the securities through the date you sell the securities.
When you file your tax return, you must deduct long-term losses from long-term gains. Then you must deduct short-term losses from short-term gains. Next, you must combine your net long-term gain or loss with your net short-term gain or loss. The final amount is reported on your individual tax return.
If you have a net long-term capital gain, you may benefit from a preferential tax rate. On the other hand, if you show a net loss for the year, it may offset capital gains plus up to $3,000 of highly taxed ordinary income (such as W-2 wages). Understanding these basic concepts will be instrumental in your harvesting plans.
Long-Term Capital Gain Rates
Under current tax law, the long-term capital gains tax rate for most taxpayers is 15%. The current maximum tax rate on ordinary income is 37% (more than double the 15% long-term capital gains tax rate that most people pay).
However, the 15% rate increases to 20% for taxpayers above certain income thresholds. Prior to the Tax Cuts and Jobs Act (TCJA), the capital gain rates were aligned with the ordinary income tax brackets. But, under the TCJA, the rules have been changed to reflect other income thresholds, indexed for inflation. For 2021, the 20% rate applies to single filers with taxable income above $445,850 ($501,600 for married people who file jointly).
Conversely, some investors, such as your children, may benefit from a rock-bottom 0% long-term capital gain rate. The 0% rate in 2021 applies to single filers with taxable income under $40,400 ($80,800 for married people who file jointly). Certain high-income individuals (such as retirees) might also have a portion of their annual income taxed at the 0% rate if they have no or little employment income.
To fine-tune your harvesting strategies, examine your portfolio to determine the gains and/or losses you’ve recognized earlier this year. Follow this basic approach:
- If you’re showing a net gain, you can harvest capital losses from securities sales that will offset your capital gains, plus up to $3,000 of ordinary income. Any excess is carried over indefinitely.
- If you’re showing a net loss, you can harvest capital gains from securities sales. The gains are absorbed up to the amount of the loss, so you’ll pay zero tax on the gains. Any excess gain is taxed as either long-term or short-term gain, depending on how long you’ve held the security.
In particular, you may decide to sell securities that would produce a short-term gain that can be absorbed by a loss. Normally, the gain would result in tax at your top ordinary income rate. All other things being equal, hold onto securities that will produce a long-term gain.
Similarly, if you have a short-term gain, it makes sense to realize a loss that would offset the gain, to avoid tax at ordinary income rates.
Important: Taxes are a major financial factor when considering securities sales. But there are other relevant reasons to buy or hold certain securities.
Beyond Capital Gains and Ordinary Income Taxes
There may be other tax ramifications resulting from securities sales. For example, if you’re an upper-income investor, you may be liable for a 3.8% net investment income tax (NIIT) on top of your regular capital gains tax. Currently, the NIIT can push the overall federal tax rate on some gains to 40.8% in 2021 (37% + 3.8%).
Depending on the tax laws in your state, you may also have to factor state income tax considerations in the mix. Some states tax laws differ from federal tax laws.
For More Information
Contact your tax advisor to help develop a plan for harvesting gains and losses that meets your needs. He or she is monitoring new tax law developments and can help you pivot as needed in the current tax year.