Selling Profitable Investments as Part of a Year-End Tax Strategy

William Perez for About.com writes: Individuals may want to consider whether selling investments that have appreciated in value before the end of the year. Selling off profitable investments increases income taxed in 2013, but there are some ways that some of those profits can be tax-free.

Taxpayers in the two lowest tax brackets of 10% and 15% may especially want to consider selling profitable long-term investments. The 15% tax bracket ends at $36,250 of taxable income for single filers and at $72,500 of taxable income for married couples filing jointly using the 2013 tax rates. Taxable income means total income after various deductions have been subtracted, such as the standard deduction and personal exemptions.

Long-term gains are taxed at zero percent to the extent that those long-term gains fill up taxable income to the top of the 15% bracket. Long-term gains are taxed at 15% for taxpayers who fall in the 25%, 28%, 33%, or 35% tax brackets. And long-term gains are taxed at 20% for taxpayers who fall in the top tax bracket of 39.6%. Short-term gains are taxed at the ordinary tax rates and are not eligible for the lower long-term gains rate. Short term means an investment has been owned for one year or less; long term means an investment has been owned for more than one year.

What we're looking for is the opportunity to sell long-term investments at a profit and have those profits taxed at zero percent. How would this work? Let's take an example.

Francis earns $40,000 in wages. He's single, and usually takes the standard deduction and one personal exemption for himself. Let's assume he doesn't have any other deductions or adjustments to income. Also, Francis has a portfolio of investments consisting of stocks, bonds and mutual bonds. We're going to figure out how much Francis could sell (if he wanted to) and have his investment profits taxed at zero percent.

First, we'll calculate his taxable income, based on his situation right now without selling any investments. He has wage income of $40,000, and from this we subtract hisstandard deduction ($6,100 for 2013 for a single person) and we subtract his personal exemption ($3,900 for 2013). So Francis has taxable income of $30,000, tentatively.

Next, we look to see what tax bracket Francis is in. For a single person in 2013 with taxable income of $30,000, Francis falls within the 15% tax bracket (using the 2013 tax rates).

We notice that the 15% tax bracket ends at $36,250 for a single person in 2013.

So, Francis could, theoretically, sell long-term holdings where the gain would be $6,250 or less and have those gains taxed at zero percent. (In other words, we're finding the difference between the top of the 15% tax bracket and the person's tentative taxable income for the year. We're trying to "fill up" the 15% bracket, so to speak, by using long-term capital gains income.)

Francis would have to look at his portfolio carefully to figure this part out. Gains are calculated by taking the selling price (what he could sell his investments at on the open market) and subtracting his cost basis, which is the cost of the investment. What Francis would be looking for is some way to mathematically generate $6,250 of gains.

Now it may be the case that the person doesn't really prefer to sell off his profitable positions. But here's a neat tax trick. Profitable investments can be re-purchased immediately. You may remember there's a rule about not repurchasing an investment within 30-days of selling it. That's called the wash sale rule. But the wash sale only applies if the person sold the investment at a loss. Since trades with gains are not subject to the wash sale rule, investors can book some of their capital gains and then buy back those investments so as to remain invested in the market. This presents an opportunity to book some gains at no additional tax cost.

Of course, there are some issues to be aware of. If an investment is re-purchased, it will have a new cost basis and a new holding period.