Managing Capital Gains

Often we hear about the wealthy using accounting tricks and loopholes to avoid paying taxes (or at least delay paying them).  What they are actually doing is waiting to realize gains until opportune moments.  With the capital gains rates about to go up when the 2003 tax cuts expire, I wanted to share some of these tricks.  Even though there are plenty of middle-class earners who see capital gains on stocks, it is unlikely that these filers would be exempted since any type of investment gain is normally seen as the territory of the wealthy.  If you will be taxed like the wealthy, it makes sense to learn some of their tricks.

Let me first stress emphatically that I AM NOT A FINANCIAL PLANNER OR ACCOUNTANT.  I am an engineer and an investor.  The information I am giving I believe to be accurate, being built up over years of investing, but I use an accountant to prepare my taxes and you should too.  Remember that the rules do not always follow logic, so check with a professional to be sure.  There are also constant changes, so it always pays to check.

The first trick is a central theme of this blog.  That is the delay of capital gains taxes by holding for a long period of time and infrequently selling shares and realizing gains.  Many point to Bill Gates and Warren Buffett as “rich” individuals, and indeed they are, but I would not be surprised to find that their tax bills are not all that large.  The reason is that even though they have billions of dollars worth of stock, mainly in their own companies, they only sell a few shares each year.  Because they do not close the transaction and actually book the profit, they are not taxed even if their stock doubles and their “net worth” thereby doubles. 

In fairness, they do not have access to the money until they sell the shares (with one caveat), and they continue to put the money at risk, so they really do not make income unless they actually sell the shares.  Also, if they actually tried to sell all of their shares, it is unlikely they would find enough ready buyers, so the price of the shares would go down.  This would be partly due to the number of shares they were selling, and partly due to the effect of having the luminaries unloading their shares.  (The caveat is that they would be able to borrow against the value of their shares, and thereby make use of the money.  If one understands how rich people think and how they evaluate risk, however, it is unlikely that many would take advantage of this option.)

The second trick is to use offsetting losses.  If you make a gain of $20,000, and you sell a loser at a $20,000 loss, you will not owe any taxes.  Actually, you can deduct up to $3000 in losses against ordinary income (again, check with a CPA).  Once again, because you are both losing money and gaining money, this “trick” is really no trick at all.  Your net worth did not increase at all due to the trades.  So when one of your picks does not work out, see if you also have a gain that has grown too big and pare it down to size.  This takes some of the sting out of the loss, which is a good psychological benefit.  When one has a loss to sell one could also sell shares of a winner and then buy it back immediately (note here also that because you are booking a gain, the wash rule does not apply and you can buy back shares of the profitable stock immediately).  This would raise one’s cost basis, so when the shares are ultimately sold the taxes on the sale would be less.

A final “trick” is to delay gains into the next tax year.  In general, if you can delay booking gains and bring forward the booking of losses or expenses, it is a good thing.  (The exception is when you will be making a lot more money in the following year, or in cases like this year when capital gains rates may jump).  This can be done by waiting until after the new year to sell a winning stock.  Because this can be risky (it is easy for a stock to fall in price enough to offset any tax gains) tactics such as selling short against-the-box or buying a put option to insure the shares against loss might be used.  Again again, check with your CPA.

So, start thinking like a rich man in your trades.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

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