Benjamin Franklin once stated, “In this world, nothing is certain except death and taxes.” The IRS recognizes realized capital gain, regardless of whether you reinvest them. There are strategies investors can use to defer or reduce capital gains taxes depending on the investment amount and how long they were held.
Tax-Favorable Retirement Accounts
Stocks, funds, and other securities can be reinvested in IRAs, 401(k), or other tax-favored retirement accounts. They can also be bought or sold without any tax consequences. Transactions such as stock purchases and sales, exchanges between mutual fund funds, capital gains distributions, and dividend reinvestments, as long as the funds remain in retirement accounts, are not subject to tax. If you withdraw securities from your retirement account before 60 1/2, taxes and other penalties will apply. Withdrawals are treated as ordinary income.
Roth IRA accounts allow you to reinvest capital gains and avoid paying taxes by adding after-tax dollars to your contributions. Qualified distributions are exempt from tax on investment gains, unlike regular IRAs. The IRS requires taxpayers to be at least 59 1/2 years old and make withdrawals within five years. There are some exceptions, such as first home purchase, birth, adoption, or college expenses. If you follow the rules for qualified distributions, Roth IRA withdrawals are exempt from tax.
Investing in Real Estate
Taxes on capital gains can be deferred by investing in Qualified Opportunity Zones or through a 1031 Exchange.
A 1031 exchange is where the taxpayer sells an investment property or business and replaces it with another comparable property. All proceeds from the sale are not recognized; instead, they are reinvested in the replacement property. The IRS has strict rules to determine whether a transaction is eligible for capital gains tax deferment. Capital gains are realized when a property is sold, and the taxpayer does not exchange it. Taxes must be paid.
Qualified Opportunity Zones were created by the Tax Cuts and Jobs Act 2017. They allow investors to reinvest with no tax consequences. You can defer capital gains tax by reinvesting in a QOZ until December 31, 2026. However, you must recognize this date before then. Reduced tax liabilities can also be a benefit to taxpayers. A QOZ investment held for five years or more before 2026 ends can result in a 10% reduction of the initial capital gains tax liability. If investments are held for more than ten years, their tax basis will increase to fair market value. This will erase capital gains tax within QOZ.
Capital gains cannot be reduced or delayed until an asset is sold. As such, it is not possible to defer or reduce your capital gains tax liability. Your best defense as an investor is to stay invested long-term. A tax specialist and financial advisor is the best choice to develop a strategy for your investments and work towards your goals.