Remember the thrill of experiencing a financial windfall? Perhaps it was from the sale of a home you renovated, a business you started, or stock gifted from a family member that brought a sense of accomplishment and joy.
What if you found out, after the sale, that instead of only a small amount or no taxes being owed, your tax bill was close to 50% of the profit? Because you did not consider tax planning before selling the asset, the proceeds you planned to spend on a new car, kitchen remodel, or vacation must now be paid immediately to the government instead.
Here are some cautionary examples of when assets were sold without planning for taxes and how to avoid these mistakes.
Outdated or incorrect advice
As a simple example, you have heard how capital gains tax rates are lower than ordinary tax rates, which is true. Long-term federal capital gains are taxed at 0-20%. However, to qualify for those lower rates, you must hold the asset for over a year. Otherwise, the sale is taxed as a short-term capital gain at 10-37% ordinary tax rates. Add in state taxes, and your tax rate can approach 50% if you did not hold the asset for more than a year.
Many other holding periods and restrictions can be found throughout the IRS Code. For example, if you want to take advantage of the exclusion available when you sell your residence, according to the IRS, you must have owned the home and used it as your residence for at least 24 months of the previous 5 years unless certain exceptions are met.
Since your primary residence is generally the largest asset you will sell in your lifetime, here is another common tax planning mistake. Even though it has not been true for some time, many still believe you will pay no tax if you trade up to a more expensive home. Also, the excluded amount on home sales is only $250,000. It is only $500,000 if your filing status is married filing jointly.
The cost of not qualifying for the $500,000 exclusion could result in an additional $100k in federal taxes.
Not documenting losses and costs
A married couple, both medical doctors, neglected to report their many rental property activities on their tax returns because their preparer said their high income prohibited them from writing off the passive losses they incurred. Therefore, they assumed there was no reason to include the income and expenses on their returns.
When they disposed of the properties, those passive losses they did not report could have been written off against the sale proceeds. Not keeping track of and reporting those accumulated losses resulted in the couple paying several hundreds of thousands of dollars in taxes they should not have owed.
Another mistake is that some do not report capital losses, generally on stock sales, because they believe the losses are limited to $3,000. While it is true that the losses are limited, any losses in excess of $3,000 can be carried forward on your individual return to offset future gains.
The same is true for charitable contributions and some forms of accelerated depreciation. You can carry those excess deductions forward to future years.
If someone says, “Don’t bother” to keep track of losses or expenses, seek another opinion. For instance, those capital improvement expenditures for your home can be used when you sell. In many cases, the documented improvements over the years, like roofs, patios, and pools, can eliminate the gains on the sales of homes. Keep those receipts and use them later!
The danger of corporations
While the use of entities like LLCs and corporations can often offer asset protection, tax, and estate planning benefits, there are many tax ramifications when you eventually sell assets that are no longer owned by you personally.
For example, we often advise clients not to hold appreciable assets in their closely held corporations. Why? When you sell an asset held by a corporation but want to use the sale proceeds personally, the taxes will often be much higher than if the asset was held in your name or an LLC. Since the asset belongs to a corporation and not you, you must somehow transfer that asset or the profit from the asset’s sale from the corporation to you as a shareholder.
One client put all her properties in several C-Corporations just before death and left it for her kids to figure out what to do. They would have paid no taxes had she not put the real estate in the corporation. The trustee also had to file unnecessary corporate returns and close the corporations.
Unfortunately, new business owners often elect to be an S-corporation without considering what will happen when they sell the business. (I also think clients assume that since the S stands for small and they are a small business, they figure they must be an S-Corporation. This is not the case.)
If, instead of electing to be an S-Corporation, they chose to operate as a C-corporation, with some other qualifying factors, they could pay little or no tax when the business sells five or more years in the future. One business owner could have saved $300k in federal and state taxes on selling $1 mil in stock. For more information, read about Sec. 1202 small business stock here- https://www.sba.gov/blog/qualified-small-business-stock-what-it-how-use-it.
Instead of using an online or do-it-yourself incorporation service, work with a qualified attorney and knowledgeable accountant and ask questions to avoid making costly planning mistakes.
A renowned tax attorney and educator of other attorneys with fifty years of experience offers profound insight: “Paying an income tax is a reflection that something good has happened, not something bad. As a result, the fact a tax related event has occurred is, almost always, a reason to celebrate.”
Just make sure to do some tax planning before the sale; then, the tax savings will be an additional reason to celebrate.
Michelle C. Herting is a CPA, an accredited business valuator, and an accredited estate planner. She specializes in succession planning, business valuations, and settling trusts.
