DISCLAIMER: We're commenting on USA finance legislation.
The primary goal of all investors is to make money on their investments. Once you're fortunate enough to earn a profit on an investment, however, you also have to do what you can to keep as much as possible out of the hands of the taxman. With some assets, you can reinvest proceeds to avoid capital gains. Still, for stock owned in regular taxable accounts, no such provision applies, and you'll pay capital gains taxes according to how long you held your investment.
Let's say you own stock that may generate a significant capital gain when you sell it. It could be shared in Apple AAPL +0.1% or Amazon AMZN -2.2% that you purchased a long time ago, founder's stock in a startup that turned into a hot IPO company, or shares from employee stock option exercises or restricted stock vesting that have appreciated substantially. While most securities held over one year qualify for the favourable rate on long-term capital gains, the total tax can still be significant.
The complex federal tax code provides a few ways, depending on your income, personal financial goals, and even your health, to defer or pay no capital gains tax. If you follow the rules and consult tax experts when needed for the more sophisticated techniques, these tax-planning opportunities below do not tax dodges or loopholes that will get you in trouble with the ATO. Most are considered tax expenditures (i.e. what we tax geeks and the US Treasury Department refer to as tax-code provisions created to encourage certain activities or benefit specific categories of taxpayers).
When you sell your house for a profit, you might use the money to buy a new home immediately; you might also decide to hold onto it. The tax that you pay when making a profit from selling a house will depend on what your marital status is, how you used the home, how long you owned the home and how much profit you made. If you sell the house and use the profits to buy another house immediately, without the money ever landing in your possession, the event is generally not taxable.
When you sell your property, you create a taxable event. If you earned a profit, you would be liable for capital gains taxes. However, whether you are selling a personal residence or an investment property, you have options that can help to reduce or even eliminate your tax liability when you reinvest your funds in another property.
Capital Gain Tax Rates
Short-Term Capital Gains
Gains on assets you have held a year or less. Short-term capital gains are taxed at the same rates as ordinary income. This is the same rate that you pay on work wages, freelancing income, or interest income. The tax rate you must pay varies based on your total taxable income, but the tax rates for 2019 are between 10% and 39.6%.
Short-term capital gains, which are gains on capital assets held for a year or less, are taxed at ordinary income rates. That is, they're taxed at the same rates as the income from your job. So if you buy a house in 2019 and sell it six months later, the gain is short term.
Long-Term Capital Gains
Gains on assets you have held longer than one year. Long-term capital gains are taxed at more favourable rates. Current tax rates for long-term capital gains can be as low as 0% and top out at 20%, depending on your income. Gains on the sale of collectibles are taxed at 28%.
Long-term capital gains are the profits (or gains) earned on the sale of an asset you held for more than one year. If you buy a house in 2019 and sell it in 2021, you've held it for more than a year, and the gain is long term.
Long-term capital gains are taxed at special rates. The rate that applies to your income depends upon your tax bracket.
If your top tax rate is:
- 0 to 12 percent, you won't pay a capital gains tax on long-term gains.
- 22 percent to 35 percent, you'll pay 15 percent on long-term gains.
- 37 percent (the top tax bracket), you'll pay 20 percent on long-term gains.
How To Avoid Capital Gains Tax?
The fact that there's no way out of paying tax on reinvested gains is one key reason why tax-favoured retirement accounts are so popular. Within an IRA, 401(k), or another tax-favoured retirement account, you can make sales of stock or other investments without any immediate tax consequences at all. You can then reinvest those proceeds in new stock. Only once you make withdrawals from your retirement account will tax issues come into play.
For your taxable account, though, your best defence against capital gains taxes is to be a long-term investor. You don't have to recognise capital gains on the stock until you sell, so that gives those who invest in companies they're comfortable holding for years or even decades a leg up on short-term traders, who will end up paying a much higher tax burden.
Some argue that reinvesting gains from stock sales should be tax-free. Lacking major reform, though, investors should take steps to minimise the number of sales that force them to recognise such gains.
Deferral Of Capital Gains Via Reinvestment
Unless the property in question is real estate, you have to pay capital gains tax on a disposition of a capital asset before reinvesting the proceeds. The primary means of avoiding capital gains tax on the sale of an asset is the like-kind exchange provision under Code section 1031. Section 1031 used to apply to practically any type of property besides stock and partnership interests. The property would have to be exchanged for property of "like-kind" to avoid tax.
The passage of the Tax Cuts and Jobs Act amended section 1031 drastically limited the scope of the like-kind exchange rules to real property.
Since section 1031 is now limited to the real property unless the asset being sold is real property, you probably don't qualify for like-kind treatment. If that's the case, I can't think of any other means by which you could avoid capital gains tax before reinvesting the proceeds in another asset.
If the asset in question has not yet been sold and was used in business activity, it might be eligible for what is known as a 1031 exchange. Rental real estate qualifies! A 1031 exchange requires specific rules be followed to DEFER the capital gains bill; yes it is not eliminated, it is deferred until the replacement property is sold (but that can be deferred again with another 1031 exchange at that time). Note that some states, for example, Pennsylvania, do not recognise the 1031 exchange as deferring capital gains, so a state tax bill might still be due if the asset is in such a state.
If the asset is not business-related, then you will have a capital gains tax bill to pay; hopefully, you owned the asset for at least one year plus one day so that it receives long term capital gains treatment rather than short term capital gains treatment.
Can you avoid capital gains tax in Australia by reinvesting in another property within a specific time frame? The answer is almost certainly not. If you purchase another property within a certain amount of time, can you avoid capital gains tax? This question from Deval which says, "Hi, I've bought an investment property about five years back. My cost base is $250,000, I've got a $305,000 loan on it, and I'm going to be selling it for $400,000. I want to buy another investment property straight away. How much should I invest from the sold property to save capital gains tax?"
Well, the answer to this question Deval is that from my knowledge you can't save capital gains tax by reinvesting it in another property. Now although you may have read "Rich dad, poor dad" or a bunch of the Robert Kiyosaki books and while he does advocate reinvesting to save capital gains tax, that's in America and as far as I'm aware there's a clause in America which says if you invest within a certain period you roll over the capital gains. So you don't pay the tax on it until eventually, you sell that property down the track. But I'm not a tax accountant but as far as I'm aware that clause doesn't exist in Australia. So if you're selling a property, then you're going to be paying capital gains tax on it, and there's no rollover available to be able to move it into another investment property.
In this situation with the property valued at $400,000 and a $305,000 loan on it, to get an equity loan from the looks of it, you can probably only access about $15,000 if you decided not to sell the property instead wanted to get an equity loan you could also look, you need to talk to your mortgage broker but look at rather than selling the property if you're keen to invest. The numbers stack up, and everything works for you, you may actually be able to get a larger equity loan on your property up to a 90% loan to value ratio or even 95% loan to value ratio. You will have to pay lenders mortgage insurance on this borrowing, but it then allows you to go forth and invest in another property and not sell this property, well that may work out for you.
Deval I don't know your situation, I don't know if your definitely 100% going to sell, I don't know if this property as peaked and it's not worth keeping, but that would be definitely something I would consider. Go and speak to your mortgage broker if you don't have one, my mortgage broker can give you a call, go to onproperty.com.au/mortgage enter your name and number, and they could give you a market there. But basically, I'm afraid that the chances of you minimising or getting rid of capital gains tax by reinvesting isn't a possibility. Still, I would always speak to a tax accountant, and I am unable to give tax advice, this is only my knowledge of the situation when it comes to capital gains tax. So it shouldn't be considered as personal taxation or financial advice. I'm just covering myself there, but I hope that this has helped you and gave you some clarity on the matter.
Why Defer A Gain?
An individual's net taxable income and chargeable gains for the tax year influence the rate of tax payable on their capital gains. See the Introduction to capital gains tax guidance note.
Depending on the nature of the asset disposed of, this can result in the individual paying capital gains tax (CGT) at 20% or 28% in tax years where their taxable income and gains exceed the necessary rate threshold (£37,500 for the 2020/21 and 2019/20 tax years) but only 10% or 18% on increases in years where their net income and gains are lower than that threshold. If a gain is covered by the annual exemption (£12,300 for the 2020/21 tax year; £12,000 for the 2019/20 tax year), no CGT is due.
To optimise their CGT position, a taxpayer can reinvest the proceeds from the sale of an asset into the purchase of a qualifying investment and elect for the gain to be rolled into those replacement assets.
When the replacement asset is subject to disposal, or possibly where the investment conditions are broken, the deferred gain falls back into charge to CGT. This may be some years after the original gain arose and in many cases, the timing of the gain falling into account can be controlled by the individual.
If you have short-term losses, your marginal tax rate determines the rate you'll pay on capital gains. So, selling capital gain assets in "lean" years may lower your capital gains rate and save you money.
If your income level is about to decrease – for example, if you or your spouse quit or lose a job, or if you're about to retire – sell during a low-income year and minimise your capital gains tax rate.
When you sell a personal residence and buy another one, the ATO will not let you do a 1031 exchange. You can, however, exclude a large portion of the gain from your taxes as that you have lived in for two of the past five years in the property and used it as your primary residence. A single person can exclude his first $250,000 in gains from taxes, and a married couple filing jointly can exclude $500,000. This means that you can sell the house and do whatever you want with the income without paying taxes on it.
Dividend Reinvestment Plans
Selling stock that was purchased through a dividend reinvestment plan can be a little more complicated. You may have made your original purchase more than a year ago, but because you are reinvesting, for example, quarterly dividends, you may have some shares purchased within the past 12 months when you decide to sell. Keep good records so you can document what part of your gain is short-term and how much is long-term.
Future Reinvesting Opportunities
If you had a capital gain, there are no special rules about future investments. You may buy new shares of the same company or invest in a totally different company. Only if you had a capital loss would you need to be concerned with the wash sale rule that defines the timing between selling and then reinvesting in shares of the same company or another company in the same industry?