Most investors are likely aware that geopolitical turmoil exerts its toll on the markets and, in turn, on their investment portfolio. A massive crisis is not even necessary to impact someone’s portfolio value. Market volatility is something every stock and bond investor has to learn to endure.
How Not Having a Capital Gains Strategy Can Hurt You
A capital gain is the difference between an asset’s adjusted basis and its current value. If an asset’s value appreciates, it will have an “unrealized” gain. Unrealized means the profit exists on paper that has yet to be sold for cash. A gain only becomes realized once the asset is closed for profit.
If an investor decides they want to sell a portion of their investment portfolio to avoid the market’s gyrations, they must take serious consideration in the risk coming with that sale and the tax on their capital gains. For example, assume the investor’s adjusted basis is $1 million, this would mean the value of their portfolio sold appreciated to $2 million during their hold time and when they sell that portion, their profit will be $1 million. This is the current $2 million value, less the $1 million basis.
However, the investor does not walk away with that $1 million. Rather, the profit will be taxed at a rate of 23.8%, assuming their state doesn’t level a capital gains tax. The potential result is that they would owe the Internal Revenue Service (IRS) $238,000. While the remaining $1.762 million is still a tidy sum, it would be more beneficial for the investor to hold the tax money, rather than immediately handing it over to the government.
Minimizing or Eliminating Capital Gains Tax
There are options when it comes to minimizing or eliminating your capital gains tax. For example:
- Donate your investment to a charity and avoid paying taxes.
- “Harvest” losses in your investment portfolio to offset the gains.
- Leave it to your heirs. They receive a step-up in basis to fair-market value, meaning no taxes are owed on any gain.
Invest your gains into a Qualified Opportunity Fund. This exciting option became available on Jan. 1, 2018. While giving you some powerful tax advantages, it also allows you to “do good while doing well.”
The Benefits of a Qualified Opportunity Fund
As previously discussed, the Qualified Opportunity Zones Program, in which investors can place capital gains from an asset sale into federally designated Qualified Opportunity Zones (QOZs) through investment in certified Qualified Opportunity Funds (QOFs). These investment help build up a lower-income area, while deferring capital gain taxes until Dec. 31, 2026.
Additionally, the longer one holds that QOF, the fewer taxes one could owe. For example:
- A five-year hold gives you a 10% step-up in basis.
- A seven-year hold gives you an additional 5% step-up in basis.
- An investment held for 10 years or more means you owe NO capital gains taxes as your QOF investment appreciates.
The chart below compares the above-mentioned $1 million gain from the sale in a Qualified Opportunity Fund, versus investing the after-capital-gains tax amount of $762,000:
|Portfolio Sale: Pre-Tax Gains Reinvested in QOF||Portfolio Sale: After-Tax Gaines Reinvested in Non QOF||QOF Investment vs Non-QOF Investment Difference|
|Gain on Capital Asset Sale||$1,000,000||$1,000,000||$0|
|Amount Invested in QOF||$1,000,000||$762,000||$238,000|
|Average Annual Return on QOF Investment||7.5%||7.5%||0%|
|Capital Gains Tax Rate||23.8%||23.8%||0%|
|Total Capital Gains Taxes Paid||$202,300
|Annual Investment Appreciation||5.0%||5.0%||0%|
|Ordinary Income Tax Rate||35%||35%||0%|
|After Tax IRR||7.64%||4.74%||2.91%|
|Investment Value at End of Year 10||$1,628,895||$1,241,218||$387,677|
All other assumptions being equal, the investor could earn an after-tax incremental 2.91% -- in other words, a 61% increase over a 10-year period, simply by deciding to invest their capital gains into a Qualified Opportunity Fund, versus a non-QOF investment vehicle.
1 Assuming your total estate is under estate tax exemption limits