As 2022 begins to wind down, we caught up with Angie M. Grainger, CPA/PFS, Certified Family Office Accountant® and an Arootah consultant, on year-end tax strategies family office professionals can implement to best manage and oversee clients’ tax preparation requirements. Here, she shares her top tips.
The best way to reduce taxes is to take action before the year comes to a close.
There are three key tax planning strategies that can be important at year-end:
- Doing good tax projections
- Shifting income or expenses
- Harvesting losses
1. Tax Projections
Good tax planning is always done at the individual level, not just at the entity level. To manage taxes well, each individual (or couple) should have a tax projection prepared in November to estimate the total income flowing to them from all sources and then project the tax liability as if they did no year-end planning.
You can then do what-if scenarios on a mock-up of their tax return to identify opportunities for saving money. This is a very important step in the tax planning process because tax planning at the entity level may not have the impact you anticipated when it flows down to their personal return. It’s important to understand the character of the income at the individual level, other gains and losses they’ve incurred during the year, and any other limitations they may be subject to (such as passive losses, at-risk losses, capital losses carrying forward, investment interest or taxes, and many others).
2. Shifting Income or Expenses
In working with families who have multiple entities and generational wealth goals, there are opportunities to take advantage of taxing income or expenses in different entities or to other family members who may need the write-offs or who can take the income at lower tax rates.
The capital gains rates can be as low as 0% for taxpayers in the lower tax brackets as compared to the 23.8% capital gains rates in higher tax brackets (20% plus 3.8% net investment income tax). Distributions from the family investment partnership or the gifting of stock instead of cash can really make a difference in this way.
3. Harvesting Investment Losses
A common planning tool is to seek and sell losses held within investment portfolios at year-end. Capturing losses is optimal because some of the losses can offset other gains (such as a real-estate gain) made at the individual level as well as an offset up to $3,000 of ordinary income.
However, you can’t repurchase the same or a similar investment within 30 days, or your losses will be limited by the wash sale rules. It may not be the best time to rebalance the portfolio when you are “selling low and buying high,” but it can be great to “sell low capture the losses, and buy back at the low price in 30 days.”
In essence, this is a tax deferral strategy, but you can also be used as a tax reduction strategy.
If you bought stock for $20,000 and it’s now worth $14,000, you have $6,000 unrealized capital loss that you could use now if you sold it.
If you buy the same stock back after the 30-day wash sale period for about the same amount ($14,000), you would then have an unrealized $6,000 capital gain in the stock again once the stock price got back up to $20,000.
This accelerates the loss into the current year and defers the gain until the market is back up and you sell it (a “buy-low, sell-high” strategy, in other words). The other benefit is that the capital loss can be used against higher ordinary income rates, which reduces the actual taxes, not just defers them.
It doesn’t make sense to harvest losses the traditional way within an IRA because IRAs are not taxed on their gains or their losses. They are taxed at ordinary income rates when you take distributions.
This is a disadvantage of being invested in a traditional IRA. The portfolio increases have been converted from capital gains to ordinary income. But, when the market drops, family members over 59½ now have the opportunity to distribute assets out of an IRA at temporarily lower values and pay less money in taxes.
For example, if $10,000 was originally contributed into the IRA and it was worth $35,000 last year, they would have been taxed at the full $35,000 at ordinary rates had the distribution been taken when the market was up.
However, if the market dropped by 30% and the investment is now worth $25,000, they’ll only pay taxes on the $25,000 if a distribution is taken now. Another opportunity here is to take an in-kind distribution of the stock instead of selling the stock and distributing cash. This allows them to continue to hold their stock positions, but it’s now out of the IRA. Now, you have an investment of $25,000 which will convert any appreciation from this point into capital gains instead of ordinary income as the market rises again. This also works especially well when you have real estate that sharply drops within a self-directed IRA.
So, you can harvest losses within an IRA account by making in-kind distributions of the stock and allowing the appreciation to be taxed at capital gains rates in the future.
Looking for additional guidance to support your team? Arootah’s experienced and dedicated family office advisors guide wealthy families and family offices in making the best use of their three most valuable assets: time, money, and family.