Should you rush to take long-term capital gains before Jan. 1, when the top federal gains rate is set to rise from 15% to 20%? That depends, of course, on many factors, including whether you’ll be needing cash or otherwise wanting to liquidate a holding in the next few years anyway.
But investors often overlook another key variable: the state and local tax bite. “It’s kind of a forgotten-about tax,” reports Carl DiNicola, an Ernst & Young partner in Irvine, Calif. It shouldn’t be; 42 states tax gains and only a few of them have lower rates for long-term gains, making state tax a big deal when you take profits.
At the federal level, ordinary income such as salary is taxed this year at a top 35% rate, more than twice the gains rate. But New York City residents pay the same top 12.9% state/local rate on salary and gains. Oregonians pay a top 11% rate and Californians a top 10.6% rate on both. In fact, among the highest tax states, only Hawaii, with a top 11% rate on ordinary income, cuts long-term gains a break; they’re taxed at a top 7.25% rate.
In reality, then, you may not be deciding whether to pay a 15% tax now or 20% later but whether to pay, say, a 25% tax now or 30% later. “It may in many cases be unwise to sell something this year just to get the lower [federal] tax rate,” say Kaye Thomas, a tax lawyer and author of Capital Gains, Minimal Taxes. Here are additional pointers:
Investigate the quirks.
“Each state has little crazy rules,” says Barry Horowitz, director of state and local tax for Eisner & Lubin in New York City. New Jersey, for example, doesn’t allow taxpayers to carry forward capital losses, as is allowed for federal tax purposes. Tennessee taxes capital gains from the sale of mutual funds but not individual stocks. New Jersey, Connecticut, Kentucky and Ohio exempt gains on their own state’s bonds from tax.
A few states give relief from capital gains taxes to seniors. For residents 62 or older Georgia already exempts from its 6% tax $70,000 per couple of income from pensions, retirement accounts, annuities, interest, dividends, capital gains and rents. In 2012 the Georgia exemption for couples 65 and older will rise to $130,000, and by 2016 all their retirement income will be exempt. Delaware, Michigan and South Carolina also exempt some of seniors’ gains.
Watch your legislature.
Don’t assume next year’s state rate will be the same as this year’s. New York’s and Oregon’s recent high-earner rate hikes are supposed
to expire at the end of 2011. On the other hand, an initiative on the November ballot in now income-tax-free Washington State would impose a 5% tax on income, including gains, above $400,000 per couple and a 9% tax on income above $1 million per couple. The tax would kick in in 2012. If it passes, Washingtonians should consider taking gains on Microsoft this year–a fitting response to an initiative being pushed by Bill Gates Sr. the father of Microsoft’s founder.
Here’s how erratic state taxes can be: Last year Rhode Island had three different gains rates based on your holding period, with a rate of 1.7% for assets held more than five years. This year all gains are taxed at a top 9.9% rate. Next year the top rate for all gains (and other income) will be 6%.
Time your tax payments.
If you make a big sale this year, you’ll need to decide whether to pay the state tax owed before Dec. 31 or next April. If you’re already in the alternative minimum tax for 2010, you’ll want to put off paying state tax because the AMT doesn’t allow a deduction for state and local taxes. If you’re not in AMT for 2010 but might be next year, consider taking a sure thing–pay the taxes now and deduct them. If the AMT isn’t a danger either year, you may want to hold off paying state tax until after Jan. 1, when federal rates are likely to rise and deductions will be worth more. You’ll probably need a tax pro or at least software (and a crystal ball) to figure this one out. Penalties for underestimating state tax also have to be figured into the equation.
Consider your next move.
A plan to relocate to an income-tax-free state would be a strong reason to defer taking gains. A Massachusetts resident, for example, could escape that state’s 12% levy on gains on collectibles by selling after he retired to Florida. (Anyway, the 28% federal rate on collectible gains isn’t scheduled to rise on Jan. 1.) But be sure you (and your Picasso) really move to the new state and establish legal residency there. Change your driver’s license and spend more than half the year down South or your old state’s tax cop will come calling.
Remember the big deferral.
If you die after Dec. 31, 2010 holding appreciated assets, your heirs will likely get a “step-up” in the basis of those assets, escaping gains tax on any appreciation before your death. If you’re of a certain age and don’t need the cash, hang on.