Before tax rates rise, consider cost basis reset strategy

Before tax rates rise, consider cost basis reset strategy

With uncertainty around key tax rates as 2013 nears, many clients are looking for tactical strategies to consider in 2012 while rates are still historically low. In fact, for some clients, tax rates on long-term capital gains cannot go any lower: In the 10% and 15% tax brackets, the capital gains tax rate is zero. For other brackets, the tax rate is 15%.

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The 0% long-term capital gains rate applies to the following tax brackets:
– Single filers: up to $35,350 in taxable income
– Joint filers: up to $70,700 in taxable income

Without legislative action, tax rates on long-term capital gains will increase in 2013. Taxpayers in the two lowest tax brackets will be subject to a 10% tax rate while all others will be subject to a 20% tax rate. In fact, some taxpayers may be subject to a 23.8% rate as new taxes associated with health-care reform begin in 2013: The additional 3.8% represents a surtax on net investment income.

Certain taxpayers may be able to reset cost basis free of taxes

Taxpayers in the two lowest tax brackets may be able to sell out of appreciated stock or mutual fund positions and then repurchase these positions shortly thereafter without any tax consequences. As long as the long-term capital gains income generated from the sale does not “push” them into the 25% tax bracket, there will be no tax liability.

Consider this example:

– Retired couple with taxable income of $60,000
– They own ABC mutual fund with a current fair market value of $20,000
– Original cost basis for mutual fund is $10,000

The couple could sell ABC mutual fund (i.e., exchange into a money market fund) at a value of $20,000, resulting in a long-term capital gain of $10,000, and then repurchase the fund after leaving those assets within the money market fund for one business day (note that the “wash sale” rule only applies to tax losses).

Assuming there is no market value change in one day, and the couple repurchases the mutual fund shares at $20,000, the end result is that they have effectively reset the cost basis from $10,000 to $20,000, reducing the bite of any future appreciation in this investment, without incurring any tax liability. The couple was able to remain in the 15% tax bracket even after realizing the $10,000 long-term capital gain. (This example assumes the taxable income of $60,000 plus $10,000 in long-term capital gain equals $70,000 in total taxable income, keeping the amount below the $70,000 bracket threshold.)

As always, clients should consult with a qualified tax professional when considering any financial strategies that would change their personal tax situation.

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