Smart Planning for Expected Capital Gains Tax Increases

One of the most likely changes in the tax law will be an increase in tax rates. For example, the Biden campaign has proposed increasing long-term capital gains and qualified dividends currently at 20% up to ordinary income rates at 39.6% for taxpayers with income over $1 million. This represents a near doubling in the tax rate. In light of the possible drastic change in rates, our smartest clients are planning ahead for future capital gains.

Unconventional Tax Planning

Conventional tax planning usually defers taxable sales into future tax years in order to defer payment of tax. With expected increases in tax rates, unconventional tax planning may be recommended.

Taxpayers may wish to sell appreciated assets in 2020, to minimize the impact of an increase in tax rates. The potential advantages of such strategies must be carefully weighed against: (i) the certain cost of incurring additional taxes now; and (ii) the potential loss of a “step-up” in basis on assets owned at death (although there also is a proposal to eliminate the basis step-up).  Conversely, any capital loss harvesting, which is a year-end ritual in any other year, should be delayed until 2021 as capital gains rates would be expected to go up and the loss would be more valuable.

It is possible that the increase can be graduated. In such case, the first $1 million of gains could be taxed at lower existing rates and gains over $1 million could be taxed at higher rates. Hence, high-income taxpayers could manage gains to be annually less than $1 million and avoid or stagger major transactions resulting in larger gains into future years. High-income taxpayers should explore installment sale to defer capital gains.

Installment Sale

An installment sale under Code Section 453 involves a sale of property where at least one payment is received by the seller after the tax year in which the sale occurs. The installment method of reporting is mandatory in the case of an installment sale. Regardless, the transaction documents should clearly state that “The Parties shall treat this sale as an installment sale under the installment method pursuant to Section 453(a) of the Internal Revenue Code.”   However, a taxpayer may elect out of the installment method (for example, to unconventionally accelerate the taxable gain into 2020 (see above) to benefit from lower tax rates). Taxpayers contemplating a sale of property at a gain should consider the installment method of reporting because it typically provides favorable tax deferral in that tax is paid as payments are received rather than entirely in the year of sale.

A 2020 installment sale could be structured with two payments: a down payment at the closing of the sale and at least one more payment deferred into the seller’s following tax year. For example, a sale could close September 30, 2020, with 50% percent of the price paid at closing and the remaining 50% payable on January 2, 2021.  Generally, the ratio of the seller’s gross profit (sales price minus seller’s tax basis) to the total sale price determines a gross profit percentage. For example, if an individual sells closely-held stock for $1 million and the seller’s basis in the stock is $300,000, then the gross profit percentage is 70 percent [($1 million – $300,000) / $1 million]. Therefore, 70 percent of each payment (less interest) will be reported as taxable gain in the year of receipt.

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