Minimizing Capital Gains

Diversification comes with taxes

Overview

If you are in a concentrated position (>10% of net work in a single stock), you should generally dump large amounts of it to cut risk. Unfortunately, selling is a taxable event. This blog post explores strategies to raise your after-tax returns, by focusing on the “tax” part. It assumes you are already utilizing the standard tax-advantaged accounts well.

Before reading this section, please be familiar with:

Remember, there’s little you can do with ordinary income — but a lot you can do with the capital gains. Depending on your own equity structure and company performance, you may or may not have substantial capital gains.

General Tax Minimization

Especially in a year with a windfall and high taxation, you should be sure to use all the standard tax minimization tools.

Reducing now

Reducing future taxes on investments As you liquidate your stock, maximize contributions to every tax-free account (Roth, 529) to minimize future taxes on your investments.

If you have children, “super-fund” a 529 plan with sufficient assets so the expected balance (after appreciation) will be sufficient to pay for college entirely.

Capital Gains Tax minimization

Do the assets you wish to sell have a significant amount of their value in capital gains? Read below

Do you have over $5M?

If you meet the standard of qualified purchaser, you can invest in an exchange fund, diversifying without realizing capital gains taxes. You’ll need to keep your funds in the fund for seven years, but with this much assets, that generally won’t be a concern. Contact your local investment bank.

If not, carry on. This section is targeted for people who cannot use exchange funds.

Timing

Recall there are tax incentives to postpone selling, but holding increases risks. There are some techniques that increase the risk-adjusted returns by either cutting risk or raising return.

Stock protection trusts — cutting risk without the tax

Stock Protection Trusts allow pooling of risk, reducing the unsystemic risk associated with holding a single stock

See the following resources for more detail:

A stock protection trust can be a solid tool to hedge risk if you are optimistic about your own stock and want to hold it and/or there are heavy costs (e.g. taxes) associated with disposing it in the short-term. Accredited investors (earn over $200k a year OR over $1M in assets) only.

I’m currently building up a pool; contact me for more information.

Collars — cutting risk

If you want to shift tax liability to next year while cutting risk, you can open a zero-collar against your stock that expires in the subsequent year. If your stock sales will be taxed at a significantly lower rate the following year (or the following year is only a few months away), this can make a lot of sense.

Please read the lock-up hedging section to learn more about the strategies of using options and the tax complications associated with doing so. Feel free to contact me if you wish to explore whether using collars makes sense in your particular situation.

Moving — increasing after-tax returns

If you are currently in a state that taxes capital gains (e.g. California), you can relocate to a state that doesn’t (e.g. Washington) and sell in a year you don’t reside or work in the original state. You can use collars or protection funds to reduce your risk until your tax jurisdiction has changed.

Note that this only applies to capital gains; ordinary income events such as NQSO option exercises and RSUs will be taxed by the state in which you worked when you initially received the option or RSU (at least in CA).

Investing in Qualified Opportunity Zone funds

Qualified opportunity zone funds are special type of investment vehicles created by the 2017 Tax Cut & Jobs Act. Effectively, investors receive tax benefits by investing in economically distressed communities.

These tax benefits are very relevant to investors with sizable capital gains. If you invest $X into an opportunity zone fund, you can receive up to the following tax advantages:

Note that the above only applies federally; your state may or may not honor opportunity zone funds. California for instance does not, meaning you still pay capital gains tax (to CA) this year and your investment in the fund may be taxed.

In other words several tax incentives exist:

Notes:

It’s out of scope of this page to talk about how to invest in real estate funds (and you want to invest in reputable funds!); you may want to start with CrowdDD.

Are you charitable?

Donor Advised Funds

A Donor Advised Fund (DAF) is a vehicle to conduct the taxable donation now and worry about what charities to donate to later. Commonly used ones are Fidelity’s or Vanguard’s.

Example: dump 10 years worth of donations into a DAF with your appreciated stock. You avoid all the capital gains, de-risk your charitable giving, and might get a large tax reduction when you are in an abnormally high bracket (due to IPO related releases and sales)

Warnings

Giving to Natural persons

(other than your minor/college student children)

If you gift appreciated stock to a person, they only pay taxes (at their tax rate in their jurisdiction) when they sell. So if you have relatives and friends you’ve been meaning to gift, consider gifting your appreciated stock rather than cash.

Note for savvy readers: This is part of why stock transfers are great to give to charity - charities don’t pay taxes on capital gains they realize!

Warning: Even if your company allows it, do not transfer stock options. As ordinary income cannot be transferred, you’ll be taxed when the recipient exercises the option!

Warning 2: If you gift more than $15k (or $30k as a married couple in a community property state [e.g. California]) to a single person, you run into gift tax issues that are out of scope of this document.

Giving to your Kids

As children pay different tax rates on their income than parents, you can “move” capital gains from yourself to your minor children by transferring stock into a UTMA custodial account and selling it there. Note that this is an irreconcilable decision; once you transfer the stock, the money is your kids property — though you can choose how the kid uses it though until they are 25. (e.g. you can chose to spend it on their college education)

Federal tax

California state Tax

Executing this

  1. Open UTMA account (every broker offers them for no charge)
  2. Transfer desired amount of stock to UTMA account
  3. Sell stock in account
  4. File taxes for kid at tax time (kid will need their own return)

Warning Beware of gift tax issues described above. However, for highly appreciated equity, tax rates will limit the effectiveness of the transfers, not the $30k gift tax exclusion limit.

Future taxes

Converting to a 529

To completely avoid any investment taxes, you can convert the UTMA into a 529. In addition to the usual 529 restrictions that withdrawals must be used for education, this 529 will be restricted to the beneficiary (you can’t change beneficiaries as you can with a normal 529).

An additional benefit of this transfer is that financial aid treats UTMA-sourced 529 accounts as a parent asset and UTMA accounts as a student asset; i.e. moving assets to a 529 may reduce future impacts to need-based financial aid.

Comparing UTMAs to 529s