Tax Strategies used by Successful Investors to Reduce or Avoid Capital Gains Tax

It has been said, there are only three places your money can go: to you and your family, to charitable organizations, and to the IRS. For most people, the least favored option is the IRS.

However, it is important not to let tax avoidance undermine your financial future. It could be a bad idea to keep a stock solely to skip out on realizing capital gains.

If that stock were to fall by 50% or more, you would certainly save money on taxes, but your financial future could be gravely impacted.

This is where tax loopholes and deferral strategies come into play, and why investors seek out top advisors to help them navigate the complicated and intricate tax code. The right advice can buy time, reduce tax burdens, or even avoid them altogether without breaking any laws.

Here are some of the strategies used to reduce or avoid capital gain taxes.

Exchange Funds

Most investors know and have access to an exchange-traded fund (ETF). But what about an exchange fund?

In an exchange fund, investors who have high gains from a stock and want to shave some off to reduce concentration risk can pool their assets in an exchange or swap fund with other investors. A professional investment manager then oversees this fund. Consider it a 'you share your stocks, and I'll share mine'-type scenario. It gives participating investors diversification without triggering a tax event. The catch is that the shares must be held in the fund for seven years to reap the benefits and defer the tax.

The manager is attempting to reduce capital gain taxes for everyone, and because now you have a pool of assets, there might be some stocks that will go down in value and some that go up. So, some tax-loss-harvesting trading will take place which would reduce capital gains taxes.

Option Collars

Another way to lock in profits on securities is by creating collars, which means buying a put option and selling a call option against the underlying asset. It hedges the share price because the put creates a floor, allowing the buyer to keep the stock but offload it if it falls below the agreed-upon price, which is the strike. But buying that put will cost a premium. Therefore, calls are sold to offset the cost, giving another buyer the right to purchase the stock if it rises. The downside is that it caps any upside potential above the strike. Collars can also be helpful in timing when gains will be realized. 

Charitable Gifting

For investors who have philanthropic goals, charitable giving is tax deductible. Instead of giving cash that's already taxed, one can give their appreciated securities to a 501(c) charitable organization. This grants them a tax deduction while skipping out on capital gains tax.

Clients who want to give to charity while continuing to benefit from gains on their principal can opt for a charitable remainder trust (CRT). It allows them to transfer cash, property, or assets to an irrevocable trust that pays an income in the form of an annuity or a percent of the trust's assets for a term or until their death, upon which it goes to the selected charities.

CRTs are a win-win for both the charity and donor. The donor gets a tax deduction up front and an ongoing payment while helping a charity.

1031 Exchange 

Finally, those with an appreciated investment property who can identify a similar property to swap it with can use 1031 Exchanges. This allows the client to defer the capital gains. If they die with the property, they can get a step-up in basis which permanently removes any tax originally deferred by the exchange. 

When contemplating a 1031 exchange, most clients will engage with a Qualified Intermediary who can assist with the entire process. 

Avoiding taking capital gains to avoid owing capital gain taxes isn’t always the answer. At AP Denver, looking for ways to manage your tax situation so that you decide when, where, and to whom your money goes is a part of the financial planning process. If you, or someone you know, have questions about this topic, please reach out to us to discuss your specific situation.