Portfolio Management: Capital Gains Taxes

Almost all passive investors must deal with capital gains at some point in their journey. There are various ways to avoid paying capital gains tax under the guidance of your tax professional, however you may find some forms of capital gains more favorable than other income streams you’ve added to your portfolio.

Capital Gains

The difference between the current value of your asset versus your purchase price is considered a gain or a loss depending on if the difference is positive or negative. Thankfully, you are only taxed on gains when you or your manager sells the asset if not held in a retirement account. Timing is very important when considering to sell assets due to the various tax treatments.

Short-term Capital Gains

Holding an appreciating asset for less than a year and then selling it for a profit would result in what is referred to as a “short-term” capital gain. These are the taxes that house flippers and stock flippers (day traders) are accustomed to. Since they are in the business of constantly buying and selling, generally this is taxed the same as your active income that you get when you work for an employer.

Mutual Funds and private investments also experience these gains if the manager sees it fit to sell an asset before holding it for a year. While you didn’t make the decision, the manager has to pass those gains on to you as an owner of the fund. If this isn’t held in a retirement account, the added gains that have been distributed to you may increase your tax burden.

Long-term Capital Gains

Holding an appreciating asset for one year or more is considered long-term. Even if you don’t sell and let the gains continue to grow, they will be considered long-term capital gains. Just as with short-term gains, you will not be taxed on them until you sell. This is why holding stocks and land can be an attractive investment and can create generational wealth as they continue to become more and more valuable without having to pay taxes as they are passed from one generation to the next.

Once the asset is sold by you or you money manager, it will be taxable in the year it is sold. These gains are tax favored since the government wants you to invest in the economy. U.S. long-term capital gain tax rates range from 0% to 20% depending on your filing status.

How does this affect my passive income portfolio?

Before you make an investment decision, it is good to understand how capital gains can occur in an asset. Here’s a list of scenarios to think about for different assets in a taxable account:

Stocks

A dividend paying stock may go up in value. You will pay taxes on the dividend income and not pay taxes on the capital gains until you sell it. If no dividend, then you only need to consider when and if you should sell. If your asset loses value, and you sell, you now have a capital loss.

This can be beneficial if you have another asset that has a lot of gains. You can net them out against each other ($1 gain + $1 loss = 0 profit to tax) and can sometimes carry over losses to future years to offset other capital gains…in any asset class!

Mutual Funds

There are a few scenarios in which you may be paid capital gains by the fund manager. First is if the fund tries to replicate an index (a S&P 500 index fund for example) and the index swaps out companies it tracks, then the manager will need to do likewise by selling the companies that have been swapped out and buy the new ones.

Any capital gains, but not losses, will be sent to you typically before the end of the year. Second is if the fund is actively managed and they are trying to earn returns above a certain index (could be stocks, bonds, gold, etc.), then the manager may be buying and selling assets multiple times throughout the year trying to earn the highest pre-tax return possible.

If the fund itself earns 20% while the index earned 12%, you then will need to look to see how much of your fund’s return was based on short-term versus long-term gains and which is more beneficial to you. 

Fixed Income

Depending on where you buy them, individual CDs and Bonds can be bought and sold. The same capital gains rules apply as with stocks. 

What about outside of paper assets and stock/bond exchanges?

Private Investments

Many of these are run as funds and follow similar rules as mutual funds. One huge difference is that capital losses also get passed down to investors. This can be both a positive and a negative. A loss usually means the asset lost money when we talk about capital losses. However, like stocks, you can potentially use fund losses to offset capital gains and reduce your tax burden across your portfolio. 

Real Estate

Similar to stocks, you will be taxed when selling either in the short or long-term…or you can pass them to future generations and they can pay the tax. Let’s say you buy an investment rental property for $100k and it’s now worth $150k 6 months later and still paying you passive income. The short-term capital gain equals $50k. If you sell and put the capital gain in the bank, you’ll pay taxes on that.

The other option is you could sell, then reinvest it into another real estate deal whether it is your own or someone else’s and delay paying taxes. As long as the rules are followed, this is considered legal as of 2022 and in the U.S. it is called a 1031 exchange (referencing the Internal Revenue Code Section 1031). 

Business

Just like buying and selling shares of companies on the stock market, if you build or buy a business, your initial investment or percentage of ownership will be used as your cost basis (your contribution) to measure the gain you have when you decide to sell.

If you opted for an internet business then you may not ever sell the assets if they are connected to you and your name meaning you’ll just pay taxes based on your earnings before taxes are taken. You may possibly be approached one day to sell the copyrights, patent, or other intellectual property surrounding something you created. The same rules still apply!

If you built or bought a physical business, the assets of the business may be treated separately and the capital gains added up. In the case of 2 corporations, there are options to trade each other’s shares and forego taxes all together since nothing was technically sold!

Considerations

As you can see, depending on the passive income stream you have, capital gains can take a major or minor role in affecting your portfolio. It’s best to view your portfolio as different pieces of your investment company: Your Capital, LLC.

When you do your due-diligence on an investment, you should consider how this may affect your other investments and taxes. We do not advocate tax evasion (not paying taxes), but rather tax avoidance. The government is incentivizing you to invest in particular sectors and to earn specific income based on the tax breaks different investments get.

If something is taxed heavier, then you can either choose not to invest in it or figure out if there are any accounts, expenses, or deductions that reduce the tax liability instead of running away from paying taxes all together. It is your job as the CEO of Your Capital, LLC to actively assess investments and discover which passive income streams makes the most sense for you. Then, work with your tax and legal advisors to discover the best way to invest in those income streams.