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To Sell, or Not to Sell

The Biden administration recently released the terms of the American Families Plan, the latest in a trio of major legislative proposals that began with the American Rescue Plan and American Jobs Plan. Broadly, these plans involve a lot of government spending, so it’s not particularly surprising that they also include a series of tax hikes, mostly aimed at wealthy taxpayers. Among these provisions is a doubling of the capital gains tax rate for those whose annual income exceeds $1 million, from 20% (plus a 3.8% Medicare surtax) to 39.6% (plus 3.8%). There have been plenty of articles arguing the merits (and shortcomings) of this capital gains tax increase, but rather than writing an opinion piece, I'd like to share a few actionable ideas.

It’s worth noting that the American Families Plan has not yet been signed into law and the provisions are still subject to change. Nevertheless, for those with significant income, it's time for you and your tax advisor(s) to start planning. (On that note, let me also remind you that I am not a tax advisor, and you should consult with a qualified tax professional before taking any action.)

If your annual income is less than $1 million, or if you simply don’t care about capital gains taxes and how to minimize them, then feel free to skip to the end of the article to check out a helpful infographic outlining the entirety of the White House's spending plans. However, if your annual income does exceed $1 million, or if you expect to realize a significant capital gain that temporarily places you in that position, here are five planning strategies to consider this year:

  1.  Selling sooner rather than later. If you have an appreciated asset that you intend to sell - marketable securities, privately-held business, real estate, etc. - time may be of the essence. I'm not saying that you should let the tax tail wag the investment dog, but you might not want to wait until 2022 to trigger those capital gains and risk paying twice as much in taxes.
  2. Sitting tight. The nice thing about capital gains is that they are discretionary - that is, you don't have to sell an asset if you don't want to. What's more, tax law can, and often does, change, so if the top capital gains tax rate doubles, it may come back down under a future administration. Don't rush into realizing capital gains simply because rates are lower now; if you own a great investment, holding onto it could be the right decision. And if liquidity becomes an issue, borrowing strategies such as securities-based lending allow you to access cash without selling you investments and realizing capital gains.
  3. Tax-loss harvesting. Capital losses offset capital gains, so if you do sell an appreciated security, selling other securities at a loss can help reduce your tax bill. Furthermore, losses can be carried forward indefinitely to offset future gains. For example, perhaps you were able to capture some capital losses during the market correction in March 2020. If so, you may be able to apply those losses against realized gains in 2021 or future years.
  4. Tax-free exchanges. If you’re a real estate investor, you’re likely familiar with 1031 exchanges, which allow you to delay paying capital gains on the sale of an appreciated property by purchasing a new, like-kind property within a certain timeframe. (Incidentally, the American Families Plan also contains provisions to limit the tax benefits of 1031 exchanges). In the world of publicly traded stocks, a similar strategy exists, called an exchange fund. Say you own a large, concentrated stock position ($500k-$1m+) with significant unrealized capital gains. An exchange fund allows you to swap that security for a diversified stock portfolio without selling the position and realizing the gains (subject to a series of rules and restrictions). As always, you’ll want to consult with your financial advisor and accountant before pursuing this kind of strategy, but if you have a concentrated position and you want to diversify your holdings without incurring major capital gains taxes, an exchange fund might be worth exploring.
  5. Donating appreciated stocks. For the charitably inclined, donating appreciated stocks to a 501(c)(3) or a donor-advised fund can be a tax-smart move. Donors can deduct the fair-market value of the stock and simultaneously avoid paying capital gains tax. For example, let’s say you paid $10,000 for a stock that is now worth $50,000. By donating those shares directly to a charitable organization, you can potentially deduct the full $50,000 and avoid paying capital gains tax on the $40,000 of appreciation. The tax rules on charitable contributions are a bit complicated, so if this strategy appeals to you, talk to your accountant.

As a last, quick side note, I do find it interesting that this rule change would result in short- and long-term capital gains being taxed at the same 43.4% rate for affected taxpayers (the American Families Plan would also increase the top marginal income tax rate from 37% to 39.6%). Not that this will necessarily change those investors’ behaviors or objectives, but the tax incentive to retain appreciated stock positions for more than 12 months would be nullified. Theoretically, this would enable wealthy investors to trade more freely in taxable accounts, although I suspect most would still prefer not to surrender nearly half of their gains to the United States Treasury.

We’ll see what happens. Till then, happy planning!

And Now For Something Completely Different...

What would you do with $4 trillion? Here's a visual breakdown of President Biden's answer to that question.