By FPA member Eric S. Toya, CFP®
Benjamin Franklin is famously quoted for saying, “nothing is certain, except death and taxes.” With all due respect to Mr. Franklin, he was obviously not aware, at the time, of the long term capital gains tax rate for 2012. There is a short window of opportunity for some investors to realize long term capital gains and pay zero tax. That’s right, a zero percent tax. But what’s the catch? No catch per se, but a good handful of rules and potential “gotchas.”
How does it work?
The zero percent tax applies to realized long term capital gains for investors in the bottom two tax brackets. That is up to $35,350 for individuals and $70,700 for married couples filing jointly. Capital gains are realized when assets (such as stocks, mutual funds or real estate) increase in value and are sold at a profit. The difference between the cost basis (generally the amount paid, but subject to adjustments such as reinvested dividends) and the sale price constitutes the capital gain. Assets held for longer than 12 months are considered long term.
What to watch out for?
Just because you are under the income limit and have appreciated assets, doesn’t mean that you should rush out and sell it all to take advantage of this zero percent tax rate. Here are a few things to consider:
The capital gains is part of your income: Let’s say you are a married couple, filing jointly with a taxable income of $65,000. If you realize $10,000 in long term capital gains, the first $5,700 of the gains will qualify for the zero percent rate. However, the remaining $4,300 will be taxed at the regular long term capital gain rate of 15%. This might still be a good deal, but you should be aware of the impact.
Do you have a loss carryforward? If you are a tax smart investor, there’s a good chance that you realized capital losses during the market meltdown of 2008-09. The IRS allows you to use those losses to offset capital gains, as well as $3,000 each year against ordinary income. Many investors still have considerable capital loss carry forward amounts. If you are one of them, you must use up your capital losses before the capital gains can count toward this zero percent tax. You aren’t allowed to report capital gains and opt to continue to carry capital gains forward.
Are you collecting Social Security? Social Security benefits are never fully taxed. At most, 85% of your Social Security benefits are included as taxable income. For lower income households, the amount may be less. If you are married, filing jointly, 85% of your benefits are taxed if your combined income is above $44,000. Between $32,000-$44,000, 50% of your benefits are taxed. If you are in a low income and have appreciated assets, selling them to take advantage of the zero percent tax may cause a larger amount of your Social Security benefits to be taxed.
Not for the kids: The Kiddie Tax covers anyone 18 or younger, or up to 23 if you are a full time student. If this describes you, then investment income above $1,900 will be taxed at your parents’ top tax rate, excluding you from the zero percent long term capital gains tax. However, if you recently graduated or are otherwise not in school, and find yourself in a low income bracket, you may be able to take advantage. What’s that? You’re young, out of college with a low income, but you don’t have any appreciated investments? Check with your parents. It may make sense to gift assets to you, which you might then sell at the zero percent capital gains tax rate.
Please consult your tax or financial planning professional to help you determine whether this strategy works for you.
FPA member Eric S. Toya, CFP®, is Vice President of Wealth Management for Trovena, LLC in Redondo Beach, Calif. Eric graduated from the University of Southern California with a BS in Finance and Accounting. Eric has been quoted in national publications, including The Wall Street Journal, Money Magazine and the Los Angeles Times.