Tax-Efficient Strategies for Investments to Consider

Before going to the details of tax-efficient strategies, taxpayers should understand the types of investment income and its tax implications.

• Assets (stocks and bonds) held for more than one year, qualified dividends :  taxed at long term capital gain rates which are 0 % for those who are in the 10-12% tax brackets (including the gain), 15% for singles who earns up $434,550  and married filling jointly who earns up $488,850 (2019) and a maximum of 20% for those who earns more than these amounts.  Depending on the income, there may be an additional  3.8% medicate surcharge.

• Assets held for less than one year, corporate bond interest: taxed at ordinary income tax rates  which have a maximum tax rate of 37% depending on the income. 

Strategy 1: Tax-loss harvest to improve the return

The first tax-efficient strategy to consider is to harvest tax-loss.  Taxpayers should review their investment profiles around December of each year to determine what strategy and how to apply tax-loss harvest.

Tax-loss harvest is a practice to sell some stocks or bonds that generate a loss at year’s end.  This practice can help to offset the capital gains with the losses to lower taxes on the gain.   At year’s end, if a taxpayer has some capitals gains, the taxpayer should consider selling some investments that generate losses. This strategy can apply to the mix of stocks/securities and real estate investments.

These steps will help taxpayers to figure out whether the gain or loss is long-term or short-term before using tax-loss harvest

•            Keep track all capital gains and loss into short-term and long-term categories
•            Combine short-term gains and short-term losses together for net short-term gains or net short-term losses
•            Net long-term gains and long-term losses together for net long-term gains or net long-term losses

    Illustrations

            Example 1: 

Nicholas has a net short-term loss of $25,000 and a net long-term gain of $30,0000.  By netting them out, Nicholas would  have a $5,000 long-term capital gain which would result a 15% or 20% tax rate

           Example 2: 

Rachel has a net short-term gain of $25,000 and a net long-term loss of $30,0000.   By netting these numbers out, Rachel would have a $5,000 long-term loss.  If Rachel has a W2 income, Rachel can deduct $3,000 from the W2 income, the remaining $2,000 loss can carry forward to the future tax years until exhausted.    Looking at this example, if Rachel doesn’t use the tax-loss harvest strategy by harvesting $30,000 long-term loss, she would have to pay her short-term tax rate (same as ordinary tax rate) on $25,000 short-term gains.  If she’s in the 37% tax bracket, she would have to pay $9,250 for federal tax and state tax (rates vary by states).    Rachel can buy back the same loss stocks after 31 days of the sale to avoid wash-sale rule               

Tax-Efficient Strategies for wash-sale rule

Taxpayers can buy back loss stocks after 31 days of the sale.  Buy back loss stocks within the first 30 days of the sale will trigger wash-sale rule.  According to the rule, a realized loss on the sale or exchange of stock or securities is not recognized.  The wash-sale rule applies if a taxpayer sells or exchanges stock or securities at a loss and within 30 days before or after the date of the sale or exchange acquires substantially identical stock or securities.

Strategies to avoid wash sale:

•  Wait for at least 31 days either before or after the sale of any securities before purchasing the same securities in order to use the loss 
• If taxpayers can’t wait for 31 days before purchasing the same stocks, taxpayers should consider buying similar stocks from a different corporation to avoid wash-sale rule

  • Example 3

If a taxpayer takes a loss on the sale of Bank of America stocks, the taxpayer can’t buy Bank of America stocks within 30 days to avoid wash-sale rule.  However, the taxpayer can purchase Wells Fargo stocks within 30 days and the wash-sale rule won’t apply

• • Example 4

    • Adam owns 100 shares of A stocks with a basis of ($30,000).  He sold 50 shares for $10,000.  Fifteen days later, he purchased the same stock for $9,000.
    • Adam realizes loss of $5,000 from 50 sold shares ($10,000 realized – $15,000 cost basis) is not recognized because it results from a wash sale.  Adam’s basis in the newly acquired stock is $14,000 ($9,000 from the purchase price + $5,000 from the wash sale which is not recognized).  Remember to keep the record of the new basis ($14,000) of the newly acquired stock; most brokerages only report the purchase price which is $9,000).  This is a potential mistake which may cost taxpayers thousands of dollars in tax for not adding the wash sale amount to the basis of the stock when the stock is sold.
• Wash-sale rule is applicable to losses but not applicable to gains.  This leads to another tax strategy
  • At year’s end, if a taxpayer has a big loss from securities, the taxpayer can sell a stock with low basis to offset the loss and purchase the same stock the next day at a higher price in order to increase the cost basis for lower gain (lower tax) in future years

    • Example 5

      • December 2019, Z incurred a loss of $50,000 from B stock.  He/she also owns Apple stocks which he/she bought a long time ago at $50/share and the current price is $100/share.  Z can sell 1,000 Apple shares to offset $50,000 from the loss of B stock.  
      • Gain from selling 1,000 Apple shares = 1,000 x ($100 – $50) = $50,000.  This $50,000 gain can offset $50,000 loss from B stock which result 0 tax for the current year.
      • Z believes that Apple stock will continue to increase.  He can buy back 1,000 Apple shares the next day at $101/share.  So, the cost basis of 1,000 Apple shares now is $101/share rather than at $50/share.  When Z sells these 1,000 Apple stock at the end of 2020 at $125/share, the gain for tax purpose is $24,000 or 1000 x ($125 – $101) rather than at $75,000 (1000 x ($150 – $50)) if he doesn’t use this strategy.

Strategy 2:  Hold investments longer than 1 year and specify shares sold.

The second tax-efficient strategy to consider is to hold investments for more than one year.  Hold investments longer than 1 year (at least 1 year and 1 day) to avoid short-term capital gains which is at higher tax rates (up to 37% rate) than the rates of long-term capital gains (15% or 20% rate).  Investments, even missing one day (for example, holding period for 1 year rather than 1 year and 1 day) will subject to short-term gain tax rates.

• Taxpayers are allowed to specify shares to be sold for tax purposes.  Rules recommended as below:
  • If there is a loss, sell shares with the highest basis to maximum the loss 
  • If there is a gain, sell shares which produce long-term gain and with highest basis for lower taxes
• If the shares sold are not specified,  “first-in-first-out” (FIFO) rule will apply to shares sold. 
• For Employment Stock Purchase Plans strategy, please visit the post All You Need To Know About Employment Stock Purchase Plans – ESPP

Example 4:

               May 2017, Sam purchased 500 shares of A stocks at $50 per share

               August 2017,  bought another 500 shares of the same A stocks at $70 per share

               If in 2020, Sam sells 400 shares at $80 per share.  Unless Sam specifies to sell shares from a specific lot, the FIFO rule will be applied and Sam will pay tax on ($80 – $50) x 400 = $12,000 gain.  If Sam follows the above rules and he/she specify to sell shares from highest basis lot ($70), she will pay lower tax on ($80 – $70) x 4000 = $4,000 gain

• In general, some taxpayers may find it’s not worth holding the stock just simply to avoid taxes.  Holding the stock/investments longer than 1 year will result lower tax rate to a 15% or 20% rate rather than at ordinate tax rates (up to 37%) if holding the investment for less than 1 year.  Before making the decision whether to keep the investments longer to qualify for long-term capital tax rate, you may need to take into an account of many aspects:
  1. 1. 1. Whether you’re ready to sell the investment?
        2. Do you believe the investment will go up by the time you sell the investment (few months or 1 year from now)?
        3. Is the tax saving worth for the wait?

Strategy 3:  Choose tax-efficient investments

Investing in tax-efficient funds can increase the rate of return and result in fewer tax hassles.  There are several types of tax-efficient funds

• Completely tax exempt: the whole investment is exempt from tax for both federal and state taxes.  Municipal bonds issued by the state are an example of this type
• Partially tax exempt: The investment is tax free for either the state or federal but not both.  Treasury bonds which are tax exempt from the state is an example of this type 

Google search for “tax efficient investments”, a lot of recommended funds will return from the search

Strategy 4: Investments with the right account types 

•      Place high tax-rate investments into tax-deferred accounts

  • Put investments that produce ordinary income or short-term capital gains into tax-deferred accounts like traditional 401(k) and traditional IRA accounts.  Place investments with long-term capital gains or investments that pay high dividends into nontax-deferred accounts (normal accounts that taxpayers own under their name or joint names).

  • The distribution from tax-deferred accounts will be taxed at ordinary income tax rates.  Placing investments that produce long-term capital gains (15% or 20%) into tax-differed accounts will convert a 15% or 20% rate into ordinary income tax rates (maximum of 37%).  Therefore, placing wrong investments into wrong account types can cost thousands of dollars every year.

• Avoid placing real estate, tax-exempt bonds and annuities in tax-deferred accounts.

  • • In fact, all money distributed from tax-deferred accounts is taxed as ordinary income tax rates.  Placing tax-exempt bonds or annuities into 401(k) or IRA would convert tax-free interests or tax-deferred to fully taxable amount. 
    • There are tax benefits of real-estate investments with nontax-advantage accounts
      • Leverage:  borrow most of purchase price from lenders
      • Reduce tax by deducting property tax, interest, depreciation, and other expenses from rental income
      • Long-term capital gains on sale (if the property is hold for more than 1 year)
      • Ordinary losses if there’s a loss on sale (a loss can offset against the ordinary income)
    • If a taxpayer uses tax-advantage accounts to own real estate, above benefits will go away.  All distribution from the funds, including real-estate investments, will be taxed as ordinary income.  Another tax trap which impacts real estate investors is UDFI tax (unrelated debt finance income tax).  The UDFI is taxed when a retirement account invests in assets that use leverage.  In other words, to avoid UDFI tax, taxpayers can’t borrow money to purchase real-estate investments in tax-advantage accounts.    However, there’s a tax strategy to avoid this UDFI tax and it is potentially ideal for house flippers using tax-deferred accounts.  Please the blog post Hidden Strategies to Maximize Your Retirement That You May Not Know for strategies to avoid UDFI tax

• REIT stocks are ideal for tax-advantage investments

With REIT, investors can get the benefit of owning real-restate without dealing with UDFI tax and other hassles