Is Avoiding Short Term Capital Gains Possible?
When it comes to tax planning, I often get calls asking for a brilliant way to not pay short term capital gains after a taxable event has already occurred. Sadly, there are not a lot of good options. People get told what they cannot do by their other advisers, and come to me hoping for a miracle. In my own experience, this is the best of the available options on the matter:
- Don’t Incur the Tax in the First Place. Capital gains taxes are optional. You have to do something to trigger them. Don’t do it. Now the down side is, doing what it takes to trigger short term capital gains taxes results in making money. You have to decide what matters most: making the money or avoiding the tax.
- Create Deductions. Certain types of income can be offset with certain types of deductions. This includes short term capital gains. The down side is, to get the deduction, you have to spend the gain you just made. This is not good if you want to have the gain and not pay the tax too. Sadly, there is only one truly effective way to do that, which is number three.
- Die. Yes, death results in a step-up in cost basis. In community property states, the step-up in basis applies to 100% of the community property assets. This means that the short term capital gain issue simply goes away. In my experience, this is not an attractive option. The premium is too high. However, at times an accidental or unforeseen death can have an upside, at least when it comes to calculating the resulting tax burden. Death is the ultimate adventure, and the most effective of all tax avoidance devices. I do not recommend it.
- ROTH Investing. Another option that is too often overlooked is to do your investing that triggers short term capital gain inside a ROTH IRA. Of course, it has to be a self directed IRA. They have their own benefits and risks. You must carefully follow the rules. The upside is that the portfolio growth is tax free. The downside is the complexity and compliance issues.
- Charitable Remainder Trust. The last option, and my personal favorite, is to conduct the trading inside of a charitable remainder trust. Contributions are partially tax deductible based no your age, the cost basis of the contributed asset, and the retained income interest. Sale of appreciated assets inside a Charitable Remainder Trust are tax free. This means the growth is tax free. You only pay taxes on the distributions to you. The distributions are taxed on a worst in first out basis. So if the income is from short term capital gains, you are going to pay taxes at that rate. This can be better in some instances than ordinary income rates. Only the distributed income is taxed. The non-distributed gain is tax free. The down side is that your heirs get none of it when you are dead. The entire balance must go to charity. Of course, if you have taken my advice and made your Family Foundation (Donor Advised Fund) the charitable beneficiary, your family will still have a voice in how the social capital is used. If you live long enough (12 years depending on the rate of return on investments and the payout rate), you can recoup all your original amount plus some.
If you have short term capital gains, it means you made money. Stop complaining and pay the tax, or be smart enough to structure your affairs before you make the money so that it happens inside one of the tax free, tax deferred, or tax exempt options described above. That’s what we help our clients do.