Of all the taxes that get reported by the press, capital gains taxes get the least exposure despite the significant impact they have on Americans. Yes, income taxes affect everyone who has ever received a paycheck, and estate taxes are in the news all the time (even though less than 6,000 estates owed federal estate taxes in 2015). But it is capital gains taxes which are so often paid when they could have been avoided, capital gains taxes which get paid no matter what your income is, and capital gains taxes which may substitute estate taxes as government’s significant source of revenue if the estate tax is repealed by the in-coming Trump Administration and Republican Congress – and they will certainly affect more than 6,000 estates every year.
- Save Your Home Improvement Receipts
Most people are familiar with a basic capital gains exclusion when they sell a primary residence: If you have lived in a home for 2 of the last 5 years you can get a $250,000 exclusion in your cost basis when you sell the house. So, if I purchase my house for $300,000, and I sell it for $700,000, the $400,000 capital gain is reduced by $250,000, meaning I only owe capital gains taxes on $150,000.
But what about the new garage I installed? Or the third bathroom I added, or the porch I built in the backyard? I could use these additional expenses to further increase my cost basis…but only if I can prove it with receipts. And some, such as new paint, are per-se maintenance, and not added to basis. I see this problem all the time: People are entitled to additions to their cost basis but lose it because they can’t prove the costs of the improvements to the properties.
- Track Your Investment’s Cost Basis by Saving Trade Confirmations
If I buy IBM stock at $30 a share today and 25 years later sell it for $80 I have a capital gain of $50 per share of IBM stock. However, if I bought the investment in 1992 at one brokerage house, then moved my investments to an online brokerage, then later move it again to another brokerage house (etc.), I am going to have a hard time proving my cost basis. And the IRS is in no mood to listen to you say what your unproven cost basis is, and will start off by saying you have a $0 basis, thereby owing capital gains taxes on the full $80 per share.
This problem is compounded if you gift the stock to a family member, since the recipient also receives the donor’s cost basis (unless it would lead to an immediate capital loss). Plus, while it is already difficult for you to go back and prove your basis, imagine how much harder it will be for your beneficiaries who don’t even know when or where you bought the stock from.
- Prepare for Pre-Mortem Sales if “Step Up In Basis” Rules at Death are Repealed
It seems only death can (currently) solve the woes of tracking cost basis, since when you pass away you get a “step up” to today’s market value of the asset. So your $80 IBM stock now goes to the beneficiaries of your estate for $80, and your house that you bought for $300,000 steps up to $700,000. This tax treatment is great for clients: When your beneficiaries sell the asset the day after your death, they do not owe any capital gains taxes!
However, there is talk in the Trump administration of repealing the step-up-at-death basis rules. It did not happen under the Obama presidency, but it may happen under the in-coming Administration, especially, if, as the current plan now reads, the estate tax is repealed completely. This was briefly the case in 2010 when the federal estate tax was absent but step-up in basis was repealed in its stead, leaving estate beneficiaries with a modified carry-over basis to report to the IRS. And if this does happen it will definitely hurt more people: While the $5,450,000 estate tax exemption means only the wealthiest .2% will face an estate tax, repealing step-up-in-basis rules will affect everyone who is holding onto a capital asset at death, whether that be a house you bought 60 years ago or a stock you purchased when you received your first paycheck.
Be conscious of your cost basis: Keep physical and electronic receipts and trade confirmations of home improvements and investments, and keep them with your legal documents in clearly marked folders and electronic files. By doing this you should avoid paying capital gains taxes you would otherwise avoid.