by Introduction and caveats
The follow post gives some suggestions about optimal donations with respect to capital gains. I've only studied the US, so this may not be useful for those in other countries. Also, my view of the landscape of tax ideas has been narrowly restricted to my particular situation, so I can't say much about people in other circumstances. Keep in mind that I'm not a tax expert -- all of the below information is what I've gathered from reading random tax articles online -- so please correct me if I'm mistaken in any points. Most of what I've written is from memory or logical reasoning, so I haven't always cited sources, but you can find a lot of this basic info by searching around the web.
Negative capital-gains tax
Normally when you have stocks, mutual funds, or other property that has appreciated in value, this is bad news for you from a tax standpoint because you have to pay capital-gains tax. Short-term capital gains (which happen when you sell property for more than you bought it after holding it for <1 year) are taxed as ordinary income (so, if you're in the 25% marginal bracket, you'll pay 25%), and long-term capital-gains (held >1 year) are taxed at 15% for most middle/high earners. Either way, you pay some amount.
The situation changes when you're donating to charity. Common tax advice is that if you have capital gains, you should donate those properties rather than donate cash, because not only do you not have to pay any capital-gains tax, but if you have long-term capital gains, then your charitable tax deduction is equal to the fair-market value of the donated securities at the time of transfer, rather than the cost basis.
Example: Ordinarily, if you have long-term capital gains of $1000, you pay $1000 * 15% = $150 in capital-gains tax. But if you donate the stock to charity, then your tax deduction is $1000 bigger due to the capital gains. If you're in the 25% bracket, that means you save $250. The bigger the capital gains, the less you pay in taxes.
There's one proviso to keep in mind, which I quote from the article, "Avoid Capital Gains Tax Donating the Property to a Charity": "The deduction of charitable contributions of an individual is generally limited to 50 percent of the taxpayer’s adjusted gross income (AGI). However, for the contributions of long-term capital gain property, the limit is 30 percent of the AGI of the taxpayer unless the taxpayer chooses to deduct only the adjusted basis of the property instead of its fair market value."
Should you use negative capital gains to make money?
Suppose you have $1000 that you're planning to give to a donor-advised fund (DAF). "However," you think, "in view of negative capital-gains taxes, I could instead use this strategy: Invest the $1000 for a year, get a capital gain of, say, 8%, and then donate the $1080 next year to the DAF. This way, I'll be able to deduct an extra $80 from my taxes."
Yes, I think this would work. Of course, you might get a capital loss instead, but if so, you can deduct that as well (see below for more on capital losses). However, keep in mind the time value of money: A tax deduction this tax year is worth more than the same deduction next tax year. If you donate this year, you'll deduct $1000 for this tax year. If you wait, you'll deduct (in expectation) $1080 next year. But since we're assuming the discount rate is 8%, $1080/1.08 = $1000, so the present value of next year's deduction is only $1000. Another way to see this is to note that if you donate $1000 this year, it should grow to an expected $1080 in the tax-free DAF by next year.
So there's an elegant symmetry between the options, and in this simplified model, you should be indifferent between them. However, there are several caveats:
But if you already have gains, make sure to harvest them
In the previous section, I analyzed the choice of whether to invest new money into a stock for the purpose of reaping negative capital-gains tax and suggested that it's not worth it. However, if you already have a stock that has positive capital-gains, then you should consider waiting for it to be held at least a year and then donate it.
Say it's a stock with a $1000 cost basis that has already appreciated 10% to $1100. If you donate it now, you do avert $100 * 15% = $15 of capital-gains tax that you would have paid for selling it, but you don't deduct any income tax beyond the $1000 cost basis. If you wait a year with an 8% average return, the stock will appreciate to around $1188, which you can then deduct next year. That has a present value this year of $1188/1.08 = $1100, which is more than the $1000 cost basis.
In contrast, if you have a stock that has so far 0% appreciation, then if you donate now, you get the cost basis of $1000 tax deduction, and if you wait a year, you get on average $1000 * 1.08 = $1080 long-term capital-gains deduction, which translates to $1000 in present value. It's as though you have just cash in this case.
What if you have to donate now?
This situation happened to me last year. I have to donate $12K each year in order to take full advantage of a yearly employer-matching opportunity. I had several stocks, but few had long-term capital gains. Among those that had short-term capital gains, some had essentially no appreciation over cost basis, while others had lots of appreciation. Obviously I donated the stocks with long-term capital gains, but that didn't reach the $12K total. So for the short-term stocks, which were the best to donate at that time?
Interestingly, the answer depends on your expectations for future donations. If you plan never to donate again, then you should give the stocks with highest short-term capital gains, because that way you avoid paying the most tax when you sell the remaining ones.
But if you plan to give more later, then you should donate the stocks with the lowest short-term capital gains. Donating these is essentially like donating cash, and it doesn't really matter that you can only deduct the cost basis due to their being held less than a year because the fair-market value is pretty close to the cost basis. But the stocks that already have some appreciation would be wasted if donated right now because you can get a bigger deduction from those gains next year.
Capital losses and harvesting
What if the stock goes down in value? Well, if you itemize, capital losses are deductible up to $3K per year, and if you have more than that, you can carry them forward to future years.
This leads to the idea of "tax loss harvesting": If you have capital-loss securities, then sell them before the end of the year to incur the capital loss and lower your income taxes. Since in an efficient market, you're indifferent between selling a stock or holding it at any time, there's no harm to selling. When you do, you should wait 30 days until the "wash sale period" is over and then buy something new with the funds. (You can buy something new sooner as long as it's not "substantially similar" to the old one, but I prefer to wait to make sure I don't mess it up.)
Actually, there's one benefit to holding onto a stock with capital losses instead of selling it. If it does go up later, then because it started with a higher cost basis, you'll have a smaller capital gain. That said, for people who donate large amounts to charity, capital gains can be a good thing because of negative capital gains tax.
Deduction limitations
As mentioned, income-tax deductions from charitable donations are limited to 50% of AGI (30% for long-term capital-gains donations, and 30% for private foundations), although donations in excess of this can be carried forward to future tax returns for up to 5 years.
Fortunately, charitable contributions still reduce taxable income even if you pay the Alternative Minimum Tax (AMT). This benefit isn't true for many other types of deductions.
Keeping track of donations
To reduce the burden of recording my donations in a place where I might lose them, I use ItsDeductible. I enter the information when I donate, and then when I prepare my taxes with TurboTax, I can import the data directly from ItsDeductible without re-typing it. There are probably similar services for other tax-software packages, but I haven't checked.
No, TurboTax didn't pay me to say this. However, I wouldn't be averse to contributions from TurboTax for my services on their behalf.
Links
Related posts
The follow post gives some suggestions about optimal donations with respect to capital gains. I've only studied the US, so this may not be useful for those in other countries. Also, my view of the landscape of tax ideas has been narrowly restricted to my particular situation, so I can't say much about people in other circumstances. Keep in mind that I'm not a tax expert -- all of the below information is what I've gathered from reading random tax articles online -- so please correct me if I'm mistaken in any points. Most of what I've written is from memory or logical reasoning, so I haven't always cited sources, but you can find a lot of this basic info by searching around the web.
Negative capital-gains tax
Normally when you have stocks, mutual funds, or other property that has appreciated in value, this is bad news for you from a tax standpoint because you have to pay capital-gains tax. Short-term capital gains (which happen when you sell property for more than you bought it after holding it for <1 year) are taxed as ordinary income (so, if you're in the 25% marginal bracket, you'll pay 25%), and long-term capital-gains (held >1 year) are taxed at 15% for most middle/high earners. Either way, you pay some amount.
The situation changes when you're donating to charity. Common tax advice is that if you have capital gains, you should donate those properties rather than donate cash, because not only do you not have to pay any capital-gains tax, but if you have long-term capital gains, then your charitable tax deduction is equal to the fair-market value of the donated securities at the time of transfer, rather than the cost basis.
Example: Ordinarily, if you have long-term capital gains of $1000, you pay $1000 * 15% = $150 in capital-gains tax. But if you donate the stock to charity, then your tax deduction is $1000 bigger due to the capital gains. If you're in the 25% bracket, that means you save $250. The bigger the capital gains, the less you pay in taxes.
There's one proviso to keep in mind, which I quote from the article, "Avoid Capital Gains Tax Donating the Property to a Charity": "The deduction of charitable contributions of an individual is generally limited to 50 percent of the taxpayer’s adjusted gross income (AGI). However, for the contributions of long-term capital gain property, the limit is 30 percent of the AGI of the taxpayer unless the taxpayer chooses to deduct only the adjusted basis of the property instead of its fair market value."
Should you use negative capital gains to make money?
Suppose you have $1000 that you're planning to give to a donor-advised fund (DAF). "However," you think, "in view of negative capital-gains taxes, I could instead use this strategy: Invest the $1000 for a year, get a capital gain of, say, 8%, and then donate the $1080 next year to the DAF. This way, I'll be able to deduct an extra $80 from my taxes."
Yes, I think this would work. Of course, you might get a capital loss instead, but if so, you can deduct that as well (see below for more on capital losses). However, keep in mind the time value of money: A tax deduction this tax year is worth more than the same deduction next tax year. If you donate this year, you'll deduct $1000 for this tax year. If you wait, you'll deduct (in expectation) $1080 next year. But since we're assuming the discount rate is 8%, $1080/1.08 = $1000, so the present value of next year's deduction is only $1000. Another way to see this is to note that if you donate $1000 this year, it should grow to an expected $1080 in the tax-free DAF by next year.
So there's an elegant symmetry between the options, and in this simplified model, you should be indifferent between them. However, there are several caveats:
- This ignores capital-gains taxes that you might pay on the 8% return. (See follow-up comment.)
- 8% is an expected value over positive and negative possible returns. However, with saving on taxes, you get a deduction both if your capital gain is positive (because you can donate the stock at its fair market value) or if the capital gain is negative (because you can sell the stock and deduct the capital loss). Therefore, even if a stock's expected return is 8%, the expected amount of deductible income is more than 8%. (This assumes you haven't maxed out your $3K limit on capital losses for the year.)
- In practice, it's less work to donate now, and doing so doesn't incur the transactions costs of buying/selling the stock.
- Important point: Because you can only deduct the fair market value of long-term capital gains up to 30% of AGI per year, if you plan to donate more (say, 50% of AGI, the maximum allowed per year), then you'll need some cash donations too.
But if you already have gains, make sure to harvest them
In the previous section, I analyzed the choice of whether to invest new money into a stock for the purpose of reaping negative capital-gains tax and suggested that it's not worth it. However, if you already have a stock that has positive capital-gains, then you should consider waiting for it to be held at least a year and then donate it.
Say it's a stock with a $1000 cost basis that has already appreciated 10% to $1100. If you donate it now, you do avert $100 * 15% = $15 of capital-gains tax that you would have paid for selling it, but you don't deduct any income tax beyond the $1000 cost basis. If you wait a year with an 8% average return, the stock will appreciate to around $1188, which you can then deduct next year. That has a present value this year of $1188/1.08 = $1100, which is more than the $1000 cost basis.
In contrast, if you have a stock that has so far 0% appreciation, then if you donate now, you get the cost basis of $1000 tax deduction, and if you wait a year, you get on average $1000 * 1.08 = $1080 long-term capital-gains deduction, which translates to $1000 in present value. It's as though you have just cash in this case.
What if you have to donate now?
This situation happened to me last year. I have to donate $12K each year in order to take full advantage of a yearly employer-matching opportunity. I had several stocks, but few had long-term capital gains. Among those that had short-term capital gains, some had essentially no appreciation over cost basis, while others had lots of appreciation. Obviously I donated the stocks with long-term capital gains, but that didn't reach the $12K total. So for the short-term stocks, which were the best to donate at that time?
Interestingly, the answer depends on your expectations for future donations. If you plan never to donate again, then you should give the stocks with highest short-term capital gains, because that way you avoid paying the most tax when you sell the remaining ones.
But if you plan to give more later, then you should donate the stocks with the lowest short-term capital gains. Donating these is essentially like donating cash, and it doesn't really matter that you can only deduct the cost basis due to their being held less than a year because the fair-market value is pretty close to the cost basis. But the stocks that already have some appreciation would be wasted if donated right now because you can get a bigger deduction from those gains next year.
Capital losses and harvesting
What if the stock goes down in value? Well, if you itemize, capital losses are deductible up to $3K per year, and if you have more than that, you can carry them forward to future years.
This leads to the idea of "tax loss harvesting": If you have capital-loss securities, then sell them before the end of the year to incur the capital loss and lower your income taxes. Since in an efficient market, you're indifferent between selling a stock or holding it at any time, there's no harm to selling. When you do, you should wait 30 days until the "wash sale period" is over and then buy something new with the funds. (You can buy something new sooner as long as it's not "substantially similar" to the old one, but I prefer to wait to make sure I don't mess it up.)
Actually, there's one benefit to holding onto a stock with capital losses instead of selling it. If it does go up later, then because it started with a higher cost basis, you'll have a smaller capital gain. That said, for people who donate large amounts to charity, capital gains can be a good thing because of negative capital gains tax.
Deduction limitations
As mentioned, income-tax deductions from charitable donations are limited to 50% of AGI (30% for long-term capital-gains donations, and 30% for private foundations), although donations in excess of this can be carried forward to future tax returns for up to 5 years.
Fortunately, charitable contributions still reduce taxable income even if you pay the Alternative Minimum Tax (AMT). This benefit isn't true for many other types of deductions.
Keeping track of donations
To reduce the burden of recording my donations in a place where I might lose them, I use ItsDeductible. I enter the information when I donate, and then when I prepare my taxes with TurboTax, I can import the data directly from ItsDeductible without re-typing it. There are probably similar services for other tax-software packages, but I haven't checked.
No, TurboTax didn't pay me to say this. However, I wouldn't be averse to contributions from TurboTax for my services on their behalf.
Links
Related posts
