Key Tax Strategies to Consider for Capital Gains
Capital gains have received favorable tax treatment since the 1980s. They are now back in the spotlight and the favorable rates that capital gains have been enjoying may be coming to an end as the Biden administration’s tax proposals are considered.
President Biden’s American Families Plan proposes to increase the capital gains tax rate for households making over $1 million from 23.8% to 43.4% (including the 3.8% net investment tax). In addition, the Made in America Tax plan proposes to increase the tax rate for corporate taxpayers (which applies to capital gains, as well as to all other corporate income) from 21% to 28%.
Optimal tax planning for capital gains will depend on each taxpayer’s particular facts and goals. Effective tax planning should consider not only current and future tax rates, but also the potential deferral period, short and long-term cash needs, possible alternative uses of funds and other factors. If tax rates increase, taxpayers should also be prepared to consider whether it is advantageous to accelerate certain capital gains into 2021, especially when no viable deferral strategy exists.
Here are some key tax strategies to consider for capital gains.
Installment sales
In many transactions, sellers are paid a portion of the sales price at closing, with the payment of the remaining sales price deferred, for example, in the form of seller-financed notes, escrows or earnouts. For these transactions, the installment sale method defers the tax due on a proportionate amount of the gain to the year when actual payment is received. While generally cash-flow beneficial, sellers should be aware that the deferred tax payments are calculated based on the tax rate in effect in the year the tax becomes due.
Alternatively, the tax code allows sellers to “elect out” of the installment method of taxing installment transactions. Taxpayers opting to elect out must pay the tax on the full gain in the year the transaction closes, at the tax rate in effect at that time. Therefore, electing out of the installment method may be beneficial for installment sales closing in 2021 if the tax rates on capital gains increase in the later years. This strategy will also eliminate the deferred interest charge on capital gain deferrals exceeding $5 million.
Qualified opportunity zones
Tax deferral is available for capital gains that are reinvested in certain distressed communities designated as qualified opportunity zones (QOZs). There are QOZs in all 50 states, the District of Columbia and five U.S. territories.
To be able to defer a capital gain, a taxpayer must invest the gain in property or businesses located inside a QOZ, or in a “qualified opportunity fund” (QOF), shortly following the completed transaction that gave rise to the gain. (QOFs are investment vehicles that invest at least 90% of their capital in QOZ properties and businesses.) There are substantial tax benefits when investing in QOZs/QOFs:
- Tax deferral on capital gains until the earlier of the disposition of the investment in the QOZ/QOF (or other inclusion event), or December 31, 2026;
- Ten percent reduction of the deferred tax on the original gain when the investment in the QOZ/QOF is made by December 31, 2021 and is held for at least five years; and
- Exemption from tax on post-acquisition appreciation of the QOZ/QOF investment provided the investment is held for at least 10 years and is sold by December 31, 2047.
For an in-depth analysis of QOZs, see BDO’s Discussion of the Opportunity Zone Program Including Final Regulations.
Like-kind (Section 1031) exchanges
Capital gains from sales of real property can be deferred where the property is exchanged for other real property that qualifies as “like-kind.” Generally, the gain is deferred as long as like-kind replacement property is held. To qualify under the rules for deferred exchanges, precise rules must be followed. Both the sale and the acquisition of the replacement property, including the receipt and disbursement of funds, must be handled by a qualified intermediary. The identification and acquisition of the like-kind replacement property must be executed very quickly after the completion of the original transaction. Proper structuring is crucial to ensure the exchange qualifies for tax deferral.
Note that President Biden’s plan aims to repeal Section 1031 benefits for high income taxpayers, defined as taxpayers with taxable income greater than $400,000, for any gains over $500,000.
Employee stock ownership plan rollover transactions
The gain on the sale of shares of a C corporation to an employee stock ownership plan (ESOP) can be deferred provided the ESOP owns 30% or more of the corporation’s shares after the transaction. In addition to meeting other requirements, the seller must invest the proceeds from the sale in qualified replacement property (generally securities of qualifying domestic companies) during a specific period surrounding the date of the sale. The seller’s capital gain is deferred until its investment in the qualified replacement property is sold or liquidated.
For more information on ESOPs, see BDO’s Frequently Asked Questions Related to Employee Stock Ownership Plans (ESOPs).
Exclusion of gain on qualified small business stock
Non-corporate shareholders (i.e., individuals, S corporations, partnerships and other eligible passthrough entities) are permitted to exclude part or all of the gain from the sale or exchange of “qualified small business stock” (QSBS) that has been held for at least five years.
QSBS is stock of a C corporation that was received by the shareholder on original issuance for cash or services. To be considered a qualified small business, the adjusted tax basis of the corporation’s aggregate gross assets may not exceed $50 million at the time the stock was issued. The corporation also must meet a trade or business test.
The exclusion of the gain varies depending on the date the QSBS was acquired. One hundred percent of the gain on QSBS acquired after September 27, 2010 is eligible for the exclusion. QSBS acquired before this date may qualify for a lower percentage of exclusion.
The overall gain exclusion per issuer is limited to the greater of $10 million or 10 times the aggregate adjusted basis of the disposed shares. Each partner in a partnership and each shareholder in an S corporation is entitled to their own $10 million limitation on dispositions of QSBS by the partnership or the S corporation.
For more on the treatment of QSBS, see BDO’s article Qualified Small Business Stock Can Provide a Strategic Advantage to Private Equity Groups and Venture Capitalists.
How BDO can help
The rules for timing the recognition of capital gains for tax purposes are complex and contain many traps for the unwary. Further complicating these rules is the real possibility of increasing tax rates and other tax changes in the foreseeable future, which may require taxpayers to rethink and revise their strategies. BDO tax professionals can help businesses and individuals navigate the rules and possibilities, as well as assist with scenario planning for capital gains to optimize cash flow and minimize tax. For more information, contact BDO.
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