It’s hard to outrun the IRS, and it’s definitely not advisable to try. Learning that taxes are an unavoidable part of life is a rite of passage for young adults entering the workforce. By the time you’re financially stable enough to start investing, you know that there’s some kind of tax implication associated with every asset you could invest in. Since taxability is an inherent part of investing, strategizing to take advantage of it is one productive use of your resources. Making smart asset decisions requires looking carefully at how each new investment would complement your existing tax plans.
Tax and investment strategies are highly personal and should be tailored to each person, in conversation with your financial advisors. What smart asset choices look like for you also changes over time as your tax plans evolve and tax law changes and there is never any guarantee of return. But there are some common strategies that investors and their advisors use to maximize taxable assets.
Tax-efficient investing essentially describes a method of taking tax treatment into account with every investment decision. That might sound like common sense but tax-efficient investing can get pretty complex and it isn’t something that a lot of investors are comfortable doing completely on their own. Moving all the pieces of your portfolio into the right places can be a little like playing financial chess.
Tax-efficient investing and portfolio diversification are closely related. The goal is minimize your investment risk and tax bill at the same time by creating a balanced portfolio. A general rule of thumb is to keep investments that are highly taxed in tax-advantaged accounts (IRAs and 401k) and to use taxable accounts (brokerage accounts) for investments that lose less of their value to taxes. Tax-advantaged accounts have limits and rules that mean some investment types are better suited for them than others. Remember that what works for other investors isn’t necessarily right for you, though.
Think of tax-loss harvesting as an investment-specific example of the “making lemonade out of lemons” philosophy. Said another way, tax-loss harvesting is a strategy that you might use to minimize the damage when you have an investment in a capital asset that’s not performing well.
The tax policies around capital assets (including real estate, stocks and bonds) can actually have a beneficial effect on your tax bill when investments you make in these assets lose value. Selling capital assets for less than you paid for them creates a capital loss that can be used to offset any capital gains you incurred that year. You can reinvest the proceeds from the sale in a new investment.
Real estate investment
A caveat: buying investment property isn’t the right investment for everyone no matter how attractive the tax benefits might seem. Individuals who are willing to take on the risks and responsibilities of owning investment real estate may also reap those tax rewards.
The rental income you earn is of course taxable but there are a lot of deductions and other strategies investors can use to reduce that taxable income. Real estate investors are able to write off a lot of their expenses, including things like advertising, travel and legal/accounting fees. Strategic investors also take advantage of a piece of tax code called a like-kind exchange. After selling one property, an investor can avoid capital gains taxes on the sale by using the proceeds to buy a similar type of investment property. This tax perk helps investors upgrade into increasingly profitable properties. However, if you sell an investment property and elect to keep the profits or buy a different type of property, you will owe capital gains taxes.
While not a traditional investment, making gifts can be a personally gratifying and financially beneficial part of your tax strategy. There are several ways that philanthropic giving can be used as a tax-advantaged strategy. One way is by gifting taxable, appreciated assets to charity. The donor reduces their taxable income with a tax deduction and avoids the capital gains taxes they would have had to pay if they sold the assets.
Giving assets to family members and other loved ones can also be done strategically. The IRS technically considers all gifts to be taxable but also allows a gift tax exclusion that means only high-value gifts are actually taxed. (For 2023 the gift tax exclusion is $17,000 per recipient you give to. You’re allowed to make gifts to an unlimited number of recipients without taxation as long as each individual gift falls below the exclusion threshold.) Making gifts that are just under that tax threshold allows you to share your wealth while you’re here to watch your loved ones enjoy it.
Giving also gradually reduces your taxable estate so it might be an important part of your estate tax strategy… or not. Again, everyone’s different. Your financial goals, age, resources and the tax laws in your state will always affect the specific guidance your tax advisors might provide when you’re making decisions about how to use your money to maximum advantage.
Sachetta, LLC provides comprehensive tax guidance to help clients make smart asset allocation and investment decisions that maximize profit and minimize the likelihood of problems with the IRS. Contact us today.