How To Avoid Capital Gains Tax   Leave a comment

Recall that when you sell an asset, you owe capital gains taxes on the difference between your cost basis and the sale price. There are, however, at least three ways capital gains taxes can be avoided (I’m sure there may be more, but these are the ones I am aware of)

  • If the asset is a stock, mutual fund, or ETF, and you’ve held it for at least a year, and you are in the 0% long term capital gains bracket, you don’t owe any tax on the sale. Of course, this requires you to be in the 0% long term capital gains bracket, which you may not be.
  • Donate the stock, mutual fund, or ETF to charity. Of course, this is only really beneficial if you were going to donate anyway.
  • Leave the asset to your heirs in your will. Neither your estate nor the heirs will owe any capital gains taxes.

Donating Appreciated Assets to Charity

A charity, being non-profit, can sell stocks, mutual funds, and ETFs without having to pay any capital gains taxes whatsoever. Hence, by donating appreciated assets to charity, nobody ends up paying the tax on the capital gains.

Suppose hypothetical Monica bought 200 shares of VTSMX (Vanguard total stock market index, investor shares) back in January 2000, for $32.47 a share. This month, January 2015, she decided to donate the 200 shares to charity, when they were priced at $50 a share. If Monica had sold these shares herself before donating them, she would have a taxable long term capital gain of $3506. But Monica is in the 25% bracket, so should would have had to pay 15% in long term capital gains taxes – $525.90. Additionally, the charity can sell the 200 shares tax free, so they don’t pay any capital gains taxes either.

Now what if Monica had been in the 15% or 10% brackets, where there is a 0% long term capital gains tax? Well, she happens to live in a state with income tax. Even if a long term capital gain isn’t taxed, it’s still reported as income and included as a part of AGI. Hence, it will (generally speaking) also be taxable by the state. Additionally, most states do not have favorable tax treatment of long term capital gains, so Monica would owe state taxes on that.

What if Monica lived in an income tax free state like Washington? It’s possible she could have just sold it without issue. But it still causes her reported income to go up, which can cause issues with the Obamacare subsidy and financial aid for college. And it’s just much easier to not have to fill out the forms.

When you donate assets to charity, you still get the tax deduction for the market value of the asset at the time of the donation. However, recall that this tax deduction only benefits you if you already or are close to being able to itemize your deductions.

Intricacies When Donating Vanguard Mutual Funds

I’ve actually donated appreciated assets to charity before – back when the ice water bucket challenge was going around, I got nominated for it and I decided to donate to charity instead (I picked The Glaucoma Foundation instead). I decided to donate about $200.

The problem with donating a mutual fund directly is that they oftentimes have investment minimums. I wanted to donate some shares of VTSAX, which have a $10,000 investment minimum. I didn’t want to donate anywhere close to that amount, so donating the shares directly was not an option. But, recall that Vanguard can convert shares of a mutual fund to it’s corresponding ETF, if it exists, without any tax consequences. An ETF is incredibly portable because it is traded like a stock (and hence, has no investment minimum other than you buying whole shares).

Knowing this, I looked at my cost basis information on Vanguard and picked out the shares with the lowest cost basis (I use specific ID, which allows me to pick out individual shares). I bought 10.67 shares of VTSAX on August 1st for $48.41 a share. I then called up Vanguard and asked to convert some of the shares to VTI, the ETF version of the fund. Now this is where I ran into a little bit of trouble. I wanted to end up with 2 shares of VTI. However the price of VTI fluctuates throughout the day, just like a stock. Hence, it is impossible to get exactly 2 shares of VTI. The Vanguard rep said he could either convert a fixed number of shares or a fixed dollar value of VTSAX. I chose to convert 4.5 shares of VTSAX. Converting shares is the better choice in this scenario because the changes in the price of VTI (which occur during the day) are very well correlated to the change in price of VTSAX (which occurs after business close). I don’t think the percent changes are always equal – I’m not sure why that’s the case. Anyways, I ended up with 2.19 shares of VTI. I then donated the 2 shares of VTI.

In the end, the benefit was I paid $99.47 a share for VTI (after the ETF conversion – $48.41/share of VTSAX * 4.5 shares of VTSAX / 2.19 shares of VTI), whereas the charity sold it for somewhere between $103.55 and $104.16 (the letter they gave me didn’t tell me the actual price they sold the shares of VTI for). Hence, they got at least an extra $8.16 from the stock market. This assumes that they didn’t have to pay any commission to sell the ETF, which I think is reasonable – I have heard that some brokerages waive commissions for charities.

Now here’s the interesting part – the 0.19 leftover shares of VTI were automatically sold by Vanguard three days later. I asked them why this occurred, and this was because I had less than one share. You are allowed to hold fractional shares of ETFs at Vanguard, so long as you have at least one share. So, if you wish to do something like this in the future, you should shoot to convert enough shares such that you’ll have at least one ETF share left over.

Leaving Appreciated Assets to Your Heirs

This works similarly to donating appreciated assets to charity. Upon your death, if you leave appreciated assets to your heirs, your heirs inherit them with a step up in basis—that is, the cost basis for the inherited assets is the fair market value on the day of your death. Hence, nobody will end up paying the taxes for the capital gain.

For example, suppose Monica and Chandler bought 1000 shares of VTSAX last Friday (1/23/2015) for $51.45 a share. They have two children, Jack and Erica, to which they leave all their assets, split evenly. Suppose they die 48 years from now. And let’s suppose that VTSAX experienced 9% gains, on average, The rule of 72 would tell us that 48 years form now, VTSAX would have doubled 6 times – that is, risen to 64 times it’s current value. It’s decently close – the true value is 62.59. So in 2063, each share is worth $3220.26, for a total value of $3,220,260 (if this sounds staggeringly large to you, recall that these are all nominal dollars – there’s going to be a significant amount of inflation over 48 years). Now, because Monica and Chandler kept contributing to their investment account, they never actually touched the shares they bought on 1/23/2015 – they used specific ID and only sold shares bought after that date to fund their retirement.

Upon their death, Jack and Erica each get 500 shares of VTSAX. But the cost basis of these shares is not $51.45, the price that Monica and Chandler paid (and consequently, Monica and Chandler’s basis). The cost basis is $3220.26, the price on the day of Monica and Chandler’s death. Had Monica and Chandler sold these shares right before they died, they would have owed taxes on a capital gain of $3,168,810. But because Jack and Erica inherited them, the tax on that large capital gain is never paid. If Jack and Erica sold all their shares on the day of their parents’ death, they would not a single cent of tax on the sale.

This is an incredibly tax efficient way to pass on wealth to your heirs – they can get stock market gains for free!

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Posted January 25, 2015 by Fiby in Uncategorized

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