Hi, thank you for tuning into today’s Emerald GEM, which stands for Get Educated in Minutes. I’m Tom Kelley, national director of Income Tax Planning for Wilmington Trust’s Emerald Family Office and Advisory and your host for today’s podcast. In today’s GEM I’m going to discuss: Five Pillars of Income Tax Planning for the Sale of Assets.
What does it mean to save taxes on the sale of my assets? Often, one thinks saving income taxes involves the lessening the amount of gross income and/or benefiting from certain allowable tax deductions and credits. These two parts are true! For today’s podcast we are going to focus on the first part and discuss five methods or pillars that can be considered to mitigate or impact gross income.
Let’s begin with the identification of terminology we will be using to help us with our discussion. We are going to talk about Deferral, Exclusion, Elimination, Offsetting, and Character of Income subject to different tax rates. For each method, I’m going to provide a description and then I’ll share an example or two to help illustrate the technique.
Let’s begin by discussing the first pillar, Deferral – This is when the sale or exchange of certain assets may permit a postponement or payment of tax at a later point in time.
One situation involves sales of certain real estate assets known as a like-kind exchange. Sometimes it is referred to as a 1031 exchange. This numerical reference is simply the Federal Tax Code Section 1031. This permits the deferral of gains after the sale of a real estate asset, if the proceeds are used to purchase another real asset. The non-taxed gain carries over, if you will, into the newly acquired asset.
Another situation may involve the sale of a closely held business. A technique to defer may include when the sale takes place with the company’s retirement plan known as an Employee Stock Ownership Plan or ESOP. Without diving too deeply into a lot of technicalities, an owner, as a shareholder of a C corporation, with proper structuring may defer recognizing gain by rolling over the long-term gain of that company into other eligible assets.
A third situation may permit deferral of gain when the sale proceeds of an asset are collected over multiple years, called an installment sale. It is important to note that not all assets are allowed this specialized treatment. As always, please consult your tax advisor to ensure clarity. This Installment Sale methodology reports portions of the capital gain over potentially several tax years. During those future years there may be lower tax rates or opportunities to utilize various tax deductions or credits alluded to a bit earlier.
A second pillar of income tax planning for sale of assets is Exclusion – This means a computed amount of taxable gain is excluded or removed from taxable income computations. This pillar is not exclusive to business or investment assets.
One example is when a sale of certain personal assets at a gain may require payment of income taxes. Capital gains on the sale of one’s personal residence is an example. But there is an allowable exclusion for certain capital gain amounts depending on filing status such as Single or Married Filing Jointly along with other qualifying criteria.
In the prior pillar of Deferral, I mention how a business owner, as a corporate shareholder of a C corporation, may have the opportunity to potentially defer capital gain by selling the business to a company’s retirement plan. In a separate type of situation, the sale of certain C corporation shares, with qualified criteria, an amount of capital gain – possibly up to $10,000,000 of capital gain can be excluded from federal taxable income. Part of that criteria is that the stock must be Qualified Small Business Stock or QSBS. To repeat a previous theme this is an area that needs and benefits subject matter expertise from an experienced tax advisor.
A third pillar may be described as Elimination – Let’s talk about how certain built-in unrealized gain in asset holdings may be eliminated or removed upon a transaction or event.
Tax rules provide that upon the death of an individual, certain assets like stocks and bonds get an income tax cost basis adjustment to the fair market value as of that date of death. This is known by the so-called term step-up in basis, presuming the fair market value is greater than the basis
Individuals and families may employ irrevocable trusts in various estate, family, and wealth planning to remove assets from their taxable estates at death. However, assets transferred into the irrevocable trust do not receive a step-up in basis at the creator’s death. One feature that may be included in this irrevocable trust is a grantor trust provision permitting the creator to swap, substitute, or replace assets in the trust with assets owned by that creator. Importantly, the assets involved must be equal in value. At this moment, the tax rules do not treat this exchange as an income taxable event. So, how can this process help income tax planning? If the creator of a trust transfers assets to the trust that have a larger income tax basis and receives assets with a lower or lesser income tax basis, and then if that creator holds those assets at the time of death, then a step-up or adjustment basis to fair market value may occur at that point. Thus, managing the income tax impact of both personal and family-created trusts may have an opportunity to “eliminate” part of or all of a gain.
The fourth pillar to discuss is Offsetting – A realized gain from an asset sale may be reduced through deductions or tax credits.
In a year where capital gains are anticipated or occurred, deductions such as charitable giving may be beneficial to offset the gain. One may consider the timing of deductions as well. In a year with greater income, one may consider “bunching” or aggregating deductions that would normally be expended over multiple years. Another term used for offsetting gain is tax loss harvesting. In a year with capital gains, the sale of assets that have unrealized losses may be sold to offset or net against the gains. Unrealized losses mean the current value of the asset is less than its income tax basis.
Finally, the fifth pillar is Character of Assets, such that the type of gain on the sale of an asset may be taxed at different tax rates. For example, a long-term capital gain may be taxed at a 20% rate if the asset has been held for longer than one year depending on the amount of income. A capital gain computed on the sale of real estate may have a tax rate of 25% due to recharacterization or recapture of previously deducted depreciation. Collectibles may be taxed at 28%. Certain business assets may not be subjected to the 3.8% Net Investment Income tax.
Many may not be aware that different type of assets may have many categories of tax rates.
Those are our five pillars of income tax planning for the sale of assets: deferral, exclusion, elimination, offsetting, and character of income. Hopefully, this has given you some different ways to think about how to approach a potential upcoming asset sale.
Thanks again for joining us today. Please contact your Wilmington Trust advisor if you have any questions about tax planning considerations prior to or upon the sale of business, real estate, or investment assets. We would be glad to help you. See you next time!
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