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How to Avoid Capital Gains Tax on Appreciated Stock Positions

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Intro

How could the current low-interest environment and a margin agreement save you tens of thousands and possibly hundreds of thousands in capital gain taxes?

If you have asked this question…

how to not have to pay capital gains tax when I sell _____?

When you own appreciated shares from stock awards, inheritances, or wherever you have to pay capital gains tax when you sell. This is a taxable event. Capital gains tax is determined by your income tax bracket. Suffice to say, if you’re reading this that number is not zero and you will likely pay something when you sell those shares. Would you like to know how to avoid capital gains tax on those appreciated shares? What if you could have your cake and eat it too? That is to say, keep the shares as they appreciate, but also get the benefit of the cash you realize when you sell those shares.

In this article, we will cover some important points that you need to know before engaging in this “avoid capital gains taxes” strategy with your portfolio!

DISCLAIMER: As always, none of this information constitutes investment advice unless in the context of a comprehensive financial plan. Please consult a qualified financial advisor to help evaluate your situation.

 


Understand appreciated stock positions

You may have wondered how the rich and famous never seem to pay taxes on their securities investments? There’s always some story or article on how they have yet again “beat the system”. Well continue reading, I’ll show you a way that you can start winning too!

First, you need to understand what an appreciated stock position is. This would be any shares you own in a publicly-traded company that is worth more than you paid for them. Simple enough right? In most cases, I see investment property like this fall into two major categories: (1) stock awards and (2) inheritances. Investment property can obviously come from a variety of sources can come but these represent the lion’s share and will be the basis for any examples I provide.

Know the capital gains tax

The next thing you need to know about is how capital gains tax works. As of this writing, the capital gains tax is based on your income tax rate. Your short-term capital gains tax rate is equivalent to your ordinary income tax rate. For instance, if you are in the 35% income tax bracket, that is what your short-term capital gains tax will be. Short-term capital gain tax is assessed on all assets held less than one year. Long-term capital gain tax rates are more favorable and have 3 tiers: 0%, 15% or 20%. For simplicity, we will assume long-term capital gains tax treatment since it is more favorable.

Capital Gains Tax Rates

This is how those tiers are broken out.

how to not have to pay capital gains tax


Learn about margin trading

Finally, you need to understand how margin works. This is very similar to when you purchase a home and get a mortgage. As your home increases in value and/or your mortgage balance is reduced you build up equity in your home. If you choose, most states will allow you to borrow against the equity in your primary residence at competitive rates. This allows you to get the cash benefit of selling your principal residence without having to sell it or pay tax. In some cases, you can even deduct expenses associated with borrowing. In very simple terms, the same mechanism exists for the appreciated shares in your brokerage account. The custodian (where you keep the shares) will usually let you borrow against the value of any capital asset in your brokerage account at a competitive interest rate (interest only). There are several requirements to take note of which we’ll address shortly. In a nutshell, the total amount borrowed in relation to the total value cannot be 100%. This means that for every $10 of value of your capital asset you might be able to borrow 50-60%.


A Hypothetical Example of Avoiding Capital Gains Tax…

Now that you understand (at a basic level) how this works we can use an example to make it more concrete for application to your situation. Let’s say we have Bob who’s worked for Pepsi for years. Over the years he’s earned stock options and restricted stock in the form of compensation that has resulted in a large amount of his retirement nest egg with a concentrated position in Pepsi stock.

Total retirement assets: $1,675,967

Pepsi stock: $1,341,967

Percentage of Pepsi in his portfolio = >80%

Although Pepsi has been a stable source of income and reliability for years, Bob is concerned with having such a large part of his life savings in Pepsi. He’s also concerned with the fact that he’s enjoyed a tremendous ride and the shares are worth considerably more than what he paid for them and rather than be hit again with capital gains tax (he paid ordinary income tax when the awards vested) he wants another way of “monetizing” the Pepsi position he owns.

His financial advisor suggests he transfer the Pepsi stock over into an individual, taxable brokerage account at a well-known custodian. After the transfer, Bob can sign a margin agreement allowing him to borrow against the value of his Pepsi shares and receive a periodic cash payout from which he can pay the interest on the loan. Bob also likes the fact that he still receives the dividends on the shares he owns and that if he were to pass away, the shares will get a step-up in the cost basis to his wife Mary allowing her to repeat a similar strategy and avoid paying capital gains tax also.


What else might you want to know before engaging in this capital gains tax strategy with your portfolio?

Is this a silver bullet investment strategy to avoid paying taxes indefinitely?

Not really.

This is more of a monetization strategy to defer your tax liability.

How long you defer is up to you.

In the above scenario, Bob avoids taxes, but in full disclosure there are some risks. Let’s discuss them.

  1. Markets for capital assets can be volatile. No matter how an asset has performed in the past there is no guarantee that your purchase price will be lower than the current market price. For this strategy to work, you’ll want the current market price to stay above the purchase price at a minimum. So in the case that the value of Bob’s portfolio drops significantly, he will receive what is called a margin call. This means he will have to supply collateral against the loan to make up for the drop in the portfolio value. If he doesn’t, the custodian can start selling positions which will ultimately trigger the capital gains taxes we were trying to avoid. The best protection against this happening is to borrow way less than what you are eligible for. In a worst case scenario, if the portfolio drops considerably you won’t be in danger of having to sell investments and likely pay capital gains taxes.
  2. Margin terms can change. Due to the nature of markets, it is possible that instead of 50-60 cents per dollar of value that the custodian will only allow you to borrow 40 cents per dollar of value. This will impact any outstanding balances you have and what you have access to in the future so it is something to be considered and possibly trigger the margin call we discussed in #1.

Intrigued? Want to learn more?

If the answer is “yes”, I’d love to speak with you on how this strategy could not only provide a tax break for you by reducing your lifetime tax bill, but provide you with retirement income.

Let’s face it. You’ve worked hard for that money and you should be able to utilize a strategy that allows you to keep more of what you’ve worked so hard for.

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As an advocate for financial education, I love to share my knowledge in a “jargon-free” way to help you understand what it will take to win with your money!

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