Finding the right capital gains tax strategy for your client

With potential tax hikes looming, CPAs can help clients manage capital gains taxes with the right strategy.
By Barbara Bryniarski

While it may be difficult for successful investors to avoid paying taxes on the fruits of their investments, their CPAs can help them lower and manage such taxes with the right strategy. That strategy may depend on a combination of factors such as current and expected future tax rates, the client's age, and whether the client's investment portfolio is appropriately diversified considering the client's age and investment goals.

For 2021, one factor that looms large is President Joe Biden's plan to increase the top income tax rate on the wealthiest Americans from 37% to 39.6% and to increase the current maximum capital gains tax rate from its top rate of 20% to 39.6% for households making over $1 million. Whether or not these specific proposals are enacted, tax increases of some type seem quite possible. Considering that the S&P 500 was up 16% year-to-date through the end of September 2021, it's safe to say there are a lot of untaxed capital gains that the government wouldn't mind getting tax revenue from.

Moreover, Biden's plan could eliminate the step-up in basis for inherited assets with a fair market value exceeding $1 million ($2.5 million per couple, when combined with existing real estate exemptions), with exceptions for family-owned businesses and farms. Again, Congress may not necessarily go along with a change to the step-up in basis. Nonetheless, for CPAs with clients holding substantial capital assets, there are several year-end strategies that warrant consideration.

Selling capital assets now to avoid higher capital gains tax rates tomorrow

While it's unknown if Biden's planned capital gains and income tax rate increases on higher-income individuals will ultimately pass Congress, it would be prudent for CPAs to take inventory of their wealthier clients' investments and help them navigate these uncertain waters. Clients who are currently in the top income tax brackets and who are holding substantially appreciated capital assets, could potentially save up to 50% in taxes by disposing of those assets in 2021 as opposed to 2022, and reinvesting the savings in more tax-advantageous endeavors.

For example, assume that, in 2021, Mike is single and is projected to have taxable income of more than $1 million. If he sells appreciated stock in 2021 and recognizes a gain of $1 million, he'll owe capital gains tax of $200,000. If he instead sells that stock in 2022, and the capital gains tax rate is 39.6% as Biden has proposed, he'll owe $396,000, almost double what he would have paid in 2021. Likewise, if a business owner is considering selling a profitable business, completing the sale this year could be much more beneficial than completing it next year.

A sell-now strategy may be particularly appropriate for older individuals who don't have time to wait to see if a tax increase today will be reversed during his or her lifetime, as well as for anyone who wants to lock in the current low tax rates. For younger clients, there are different dynamics at play because they have more time for assets to appreciate and for a potential capital gains tax rate increase to be reversed in future years. But selling capital assets this year and using the money to invest in a tax-free retirement account as discussed below may be an option worth pursuing.

One cautionary note is that any savings from selling now may be lost if Congress backdates a capital gains rate increase, such that it takes effect before the particular transaction is completed.

If it does make financial sense for a client to sell appreciated property or investment assets in 2021, the next consideration is where to best invest these proceeds. Here are some options.

Roth 401(k)s

Numerous employers offer 401(k) plans to their employees, and contributions to such plans are a tried-and-true way of reducing current-year taxable income. But there is another option for clients whose employers offer a Roth 401(k) option. These plans allow employees to contribute after-tax amounts to their 401(k) account and later take tax-free qualified distributions. A qualified distribution is generally one made after a five-tax-year period of participation and is made on or after the date the individual turns 59½, dies, or is disabled.

An individual can contribute to a Roth 401(k) even if his or her income is too high to contribute to a Roth IRA. Distributions must begin no later than age 72 unless the employee is still working and is not a 5% owner. While an employer can make matching contributions to an employee's Roth 401(k), these contributions are only allocable to a pretax account, so distributions of matching contributions and earnings on these contributions will be taxable. For self-employed individuals, a solo Roth 401(k) is an alternative.

And it's worth keeping in mind that in the future, the nontaxable distributions from a Roth 401(k) will keep a retiree's adjusted gross income (AGI) low, which can be beneficial for deducting medical expenses and reducing taxes on Social Security income.

Qualified opportunity funds

Special tax benefits are available to individuals and businesses that invest eligible gains, which include capital gains and Sec. 1231 gains, in a qualified opportunity fund (QOF). Investors can defer tax on the invested gain amounts until the date they sell or exchange the QOF investment, or Dec. 31, 2026, whichever is earlier.

The length of time a taxpayer holds the QOF investment determines the tax benefits the taxpayer receives. If the investor holds the QOF investment for at least five years, the basis of the QOF investment increases by 10% of the deferred gain. If the investor holds the QOF investment for at least seven years, the basis of the QOF investment increases by 15% of the deferred gain. If the investor holds the investment in the QOF for at least 10 years, the investor is eligible to elect to adjust the basis of the QOF investment to its fair market value on the date that the QOF investment is sold or exchanged.

Rental homes

While commercial real estate has suffered during the pandemic, the single-family housing market continues to flourish. Investing in single-family homes can provide a steady rental income stream, tax deductions to offset that income stream, and, generally, an increase in asset value each year.

Net investment income tax

Last but not least, don't forget about the net investment income tax of 3.8% that applies to the lesser of a client's net investment income or the amount by which modified AGI exceeds the statutory threshold amount for the client's filing status. Generally, net investment income includes, but is not limited to, income from interest, dividends, capital gains, rents and royalties, and nonqualified annuities.

Congress is currently considering proposals to expand this tax to cover, for instance, net investment income derived in the ordinary course of a trade or business.

Barbara Bryniarski, CPA (inactive), MST, is an executive editor at Parker Tax Publishing. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld, senior editor, at

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