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One opportunity that investors should never pass up is the ability to convert a taxable long-term capital gain into tax-free basis — without paying taxes to do so.

This is known as harvesting long-term capital gains. It’s a process of intentionally selling an investment with a taxable long-term capital gain, in a year when — due to low income — that gain will not be taxed. Then, if you want to keep the investment, you buy it back immediately.

The income sweet spot

The gain won’t be taxed when it occurs in a year when the investor is in the “0%” long-term capital gain tax bracket, which for 2021 occurs when they have a taxable income of $40,400 or less if single; $80,800 or less if a married couple.

The genius of selling and buying it right back is that the process raises your “basis” in the investment from your original cost in the past to current fair market value.

Whenever you sell an investment, you are taxed on the increase in value over your cost basis. If in this particular year you owe no tax on the increase over basis because you’re in the 0% bracket, you nonetheless will own the repurchased investment at today’s value, reducing the taxable gain you will owe when you ultimately do sell in the future, when you are in a higher tax bracket.

And many people do end up in higher tax brackets in the future due to things like pay raises, starting Social Security or pension benefits after retirement, or taking required minimum distributions at age 72.

Even if your taxable income is normally too high to harvest gains with zero tax, there may be some years where it may fall to a point where you can take advantage of this strategy, such as when you are:

• temporarily unemployed,
• a self-employed person and your income varies from year to year, or
• between the ages of 60 and 72 and retired, before you start taking required minimum distributions.

Also, you can sometimes intentionally create a low-tax year that qualifies for gain harvesting by delaying a bonus until the next year, waiting to take taxable distributions out of retirement accounts until you’re required to do so at age 72 (or even later if you’re still working), and/or delaying your Social Security benefits until age 70.

How it can work

For example, let’s say you’re married, you just retired, and your taxable income for the year is going to be $50,000. Remember, the first $80,800 of your taxable income is taxed at a “0%” long-term capital gains tax rate — but for the sake of simplicity, and to build in a safety net so you don’t go over the limit, let’s round it down to $80,000.

Therefore, you have $30,000 of long-term capital gains you can trigger without going over the $80,000 threshold and a “0%” capital gain tax rate will apply. In other words, you can capture this gain tax-free.

If you own stocks or mutual funds in a taxable account and some of your positions have unrealized long-term capital gains, you have a tax-planning opportunity here. You can sell enough of your investments to trigger $30,000 of long-term capital gain and pay no income tax on it.

And, assuming you want to keep these investments, you could simply buy them back immediately, and the $30,000 worth of taxable long-term capital gains will be eliminated forever, with no tax consequences, when you go to sell the investments later.

You do not have to wait 31 days to buy the investments back to abide by what is known as the “wash sale” rule, because that applies only to investors taking capital losses, not capital gains.

What to watch out for

Before you use this strategy, be sure to check to see if you have any capital gains distributions that may pay out on mutual funds that you own in taxable accounts.

Mutual funds distribute capital gains each fall, although some funds distribute these funds as late as mid-December. These are gains that can be triggered even if you have not personally sold any of the mutual fund shares.

You’ll want to know what these gains are before you decide to intentionally realize additional gains. Otherwise, you could get thrown into a higher long-term capital gain tax bracket, which will be at least 15%, and end up paying tax on part of the gain.

Also, remember capital gains taxed in the 0% tax bracket are still income and will therefore increase your adjusted gross income, which could potentially increase your taxes in other areas. For example, it could result in reducing or disallowing the medical expense deduction if you itemize, or trigger the taxation of otherwise non-taxable Social Security benefits.

So, while you have to do your homework to avoid some of these tax landmines, the fact remains that strategically harvesting gains in low-income tax years may reduce your future tax liability and put more income in your pocket.

© 2021 The Kiplinger Washington Editors, Inc. Distributed by Tribune Content Agency, LLC.