How to Pay No Tax on Your Capital Gains Using a Free Step-Up in Basis

By Jeffrey Levine, Director of Retirement Education
Follow Me on Twitter: @IRAGuru4EdSlott

In order to encourage investments in companies, the tax code provides for the preferential treatment of capital gains (gain on property, such as a stock) if the investment being sold had been held for greater than one year. To illustrate this point, consider the following chart, which summarizes the ordinary income tax rates vs. the long-term capital gains rates that apply at various income levels.

Comparison of 2016 Ordinary Income Tax Rates vs. Long-Term Capital Gains Rates
 

Note that not only are the long-term capital gains rates more favorable than the ordinary income tax rates at every income level, but that for those persons in the 10% and 15% ordinary income tax brackets, the long-term capital gains tax rate is zero percent! If you’re proactive and are reasonably able to estimate your taxable income before the end of the year, you may have a fantastic opportunity to generate some tax-free income. Suppose, for instance, that you’re a joint filer, and that you estimate your taxable income for 2016 will be $60,000. That would put you squarely in the 15% ordinary income tax bracket, but you’d still have $15,300 of “free space” ($75,300 top of the 15% ordinary income tax bracket less your $60,000 taxable income) to fill up before spilling into the 25% bracket. That would allow you to sell investments with up to $15,300 of long-term capital gain and pay absolutely no income tax!

Like the investment and don’t want to sell? Then turn around and buy it right back the very next day! You could even do it the very next minute. There’s no waiting period to be concerned with here! Now you might be thinking to yourself, “Why sell it if you’re just going to buy it right back?” The answer – and the pièce de résistance of this approach – is that you’re able to lock in a “free step-up in basis.” Consider the following simplified example to help illustrate the point: Jack and Jill are married and anticipate having $60,300 of income each year in retirement. The two decide to purchase $40,000 of Stock “A,” which proves to be a good decision. Over the next year, the value of their investment in Stock A increases by $10,000. Unfortunately, they take no action and the opportunity to receive a free step-up in basis goes unclaimed. The following year, the value of their investment in Stock A once again increases by $10,000, and once again Jack and Jill do nothing. This pattern continues for the next three years, until Jack and Jill’s Stock A investment has $50,000 of gain and is worth a total of $90,000. Now suppose the couple wants to liquidate their position in Stock A, perhaps to meet living expenses or perhaps simply because they believe it is no longer a sound investment. When the $50,000 of capital gain income on Stock A is added to their $60,300 of other income, they will no longer be in the 15% ordinary income tax bracket. Their total income will be $110,300, and assuming the same $75,300 top-of-the-15%-bracket we have today, Jack and Jill will have $35,000 of income in excess of that amount. That $35,000 will consist entirely of long-term capital gains and thus, will result in a $5,250 tax liability after the 15% long-term capital gains rate is assessed ($35,000 x 15% = $5,250). While a $5,250 tax bill on $35,000 of income may not sound too bad to many retirees, it’s absolutely terrible when you realize that, had sound tax planning been executed, it could have been entirely avoidable.

Consider if, for instance, Jack and Jill had sold their Stock A investment after the first year, when it had gained its first $10,000. Their total income would have been $70,300, and the $10,000 of capital gains would have been taxed at 0%. Then, they could have turned right around, bought Stock A right back, with a basis (after-tax amount) of $50,000. The following year, when the stock increased another $10,000 to $60,000 of total value, they could have repeated the process. By repeating this process year after year (technically, they’d have to wait at least one year and a day after purchasing to sell and receive the long-term capital gains rate), Jack and Jill would never pay tax on the capital gains income, and would gradually increase their basis. In the final year of our example, they would sell their Stock A for $90,000, but with a basis of $80,000. Thus, there would once again be a capital gain of only $10,000, and once again it would be taxed at a 0% rate.

It’s not uncommon for a couple to have $100,000 or more of gross income and still find themselves in the 15% ordinary income tax bracket taking into account their deductions, exemptions, etc., so the free step-up in basis strategy is one that can be used to great effect by a large cross-section of the taxpaying public. And while the strategy won’t save you any money on your taxes today, using it could save you a boatload in the future, when you may need it even more.