Tax-Smart Strategies for Capital Gains in 2023

Experienced and successful investors know that their investment wealth faces two powerful enemies at all times: bad investments and capital gains taxes.

Invest long enough, and you will inevitably encounter an investment that could have, would have, should have — but didn’t — appreciate in value. Even Warren Buffett has picked the occasional clunker in his long and legendary career, but by cutting losers short, letting winners run, and paying close attention to position sizing and diversification principles, no investor needs to be crippled by any bad investment.

The other enemy is a stealth opponent, one that chips away steadily at even the best investors: capital gains taxes, which can siphon off up to 23.8% of the gain for investments held more than a year and as much as 40.8% for investments held for less than a year. (That’s just the federal tax — 41 states also levy their own capital gains tax, which adds an average of an additional 5% to the tax bill and can range much higher in certain states.)

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Strategies to mitigate capital gains taxes

With apologies to Mr. Franklin (and in his defense, we still haven’t figured out a way to cheat death), there are several strategies that can help mitigate or even eliminate capital gains taxes. Some of the more common ones include:

• Investing in a tax-sheltered account, such as an IRA or 401(k).
• Tax loss harvesting, which involves claiming a capital loss to offset a capital gain, such that the net effects on your tax bill zero out.
• Donating appreciated assets to a qualified charity, which enables the donor to not only support a worthy cause but also avoid payment of taxes on the appreciation.
• Deferring capital gains taxes by reinvesting the proceeds from the sale of an appreciated asset into a new investment.

It's this last category that we’d like to explore in greater detail.

1031 exchanges: Defer, or even eliminate, capital gains taxes

Named after the section of the Internal Revenue Code that spells out the rules and regulations whereby it can be executed, the 1031 exchange enables taxpayers to defer capital gains taxes on the sale of an asset by reinvesting the proceeds into a like-kind asset of equal or greater value. This is usually real estate but can include real property interests such as oil and gas mineral royalties. The 1031 exchanges are attractive to investors who are looking to maintain or expand their investment portfolio without having capital gains taxes steal away a significant portion of the gains.

Key requirements for a valid 1031 exchange

There are a few key requirements for a valid 1031 exchange. Most important, the property or properties in question must be held for investment, or for productive use in a trade or business. (This would disqualify virtually all private residences from consideration.) There are also multiple structural and timing requirements for the exchange, the most important of which is that the entire exchange must be completed within 180 calendar days of the sale of the original property.

Given the complexities involved in 1031 exchange rules, as opposed to the relatively simple purchase of an investment property, it’s no surprise that the involvement of a knowledgeable adviser is not only recommended but required by the Internal Revenue Code.

Known as a qualified intermediary, this experienced third party handles virtually every aspect of the transaction. This includes the identification of the replacement property within 45 days of the sale of the original property; the placement of the proceeds from the original sale into an escrow account until the exchange is complete; the processing of the multiple phases of the transaction, including all relevant paperwork and payment of fees; and most important, the overall management of the exchange so that the entire process is indeed complete within 180 calendar days of the original sale.

Since failure to comply with even one of the multiple requirements of Section 1031 can result in the invalidation of the exchange (and the resulting need to pay capital gains taxes on the original sale), it’s hard to overstate the importance of the qualified intermediary to facilitate the exchange. (Learn the ins and outs of a 1031 exchange and ways to leverage a 1031 exchange for your real estate investments in my comprehensive Master the 1031 Exchange Masterclass.

QOZ investing: Doing well by doing good

One of the cons of a 1031 exchange is that it doesn’t allow an investor to keep some of the proceeds of the original sale for alternative purposes without suffering adverse tax consequences. The entire amount of the original sale (or more) must be reinvested, or the shortfall amount will be treated as taxable “boot.” Investors looking to invest only the capital gain from an appreciated asset, while redeploying the remaining capital elsewhere, might do well to consider an investment in one or more qualified opportunity zones.

Unlike the 1031 exchange, which has existed in one form or another for decades, QOZ investing had its start in the bipartisan 2017 Tax Cuts and Jobs Act, which empowered each American state and territory to designate a number of distressed communities that would be targeted for new investment. The TCJA had a twofold purpose of spurring economic growth in these communities, as well as providing tax benefits to investors who would otherwise face capital gains taxes from the sale of an appreciated asset.

Currently, there are over 8,700 U.S. Census tracts that qualify as opportunity zones, and they’re located in all 50 U.S. states, the District of Columbia, and five U.S. territories. Investors seeking a specific geographic area for investment will almost certainly find one to their liking.

Also unlike the 1031 exchange, there is no “like-kind” requirement, so whether your appreciated asset is investment real estate, an art collection, a cryptocurrency investment, a stock or bond portfolio, or a cattle ranch … virtually any appreciated investment can be sold, and the portion of the proceeds that represents the investment’s capital gain can be redeployed into a QOZ fund.

By making a qualified opportunity zone investment, the taxpayer can defer payment of the capital gains tax on the original asset until Dec. 31, 2026 (the current date of the program’s expiration), or until the subsequent sale of the QOZ investment, whichever comes first.

Investors are also incentivized to hold the QOZ investment for at least 10 years, at which time any capital gains taxes on the QOZ investment itself are entirely eliminated. Of course, capital appreciation on a QOZ investment isn’t guaranteed, and investors are urged to work with an experienced adviser to do the necessary due diligence before selecting an appropriate QOZ fund. (I've also created a 50-minute Tax-Smart Masterclass to help you master the QOZ.)

Oil and gas investments: Diversification, capital gains, and ordinary income all in one

Tax-savvy investors have historically gravitated to oil-and-gas-related investments for a combination of capital gains and ordinary income. Most commonly, an investor buys shares in energy-related stocks with a history of paying robust dividends and increasing them over time — think Occidental, Marathon, Conoco Phillips, EOG, or Kinder Morgan, for example — and reinvesting these dividends over a period of years. When such an investment has time to grow in a tax-sheltered account, the results over decades can be staggering.

But what if there was a way to invest directly in the drilling or acquisition of oil and gas wells and achieve valuable and direct exposure to the energy sector without exposure to the stock market, while simultaneously locking in the tax benefits of a 1031 exchange or a qualified opportunity zone investment?

Since the passage of the TCJA, a number of funds have been created with the expressed goal of eligibility for these tax-smart strategies and diversification into the oil and gas industry, through an interest in new or existing oil and gas wells or a corresponding interest in mineral rights. Since the wells in question constitute real property, they retain eligibility for a 1031 exchange, and with some of the properties in question located in qualified opportunity zones, their status as a potential QOZ investment is also intact. These funds are inherently speculative, of course, and working with a qualified and experienced adviser is absolutely essential.

Investors who are tantalized by the possibilities of these oil and gas investments may be attracted to them even without the 1031 or QOZ structure. That’s because some funds are structured to allow investors to write off up to 90% of the amount of their investment against ordinary income. (Most states allow a similar deduction in calculating state income taxes.) The actual amount of the write-off permitted is dependent on a number of factors beyond the investor’s control, and as always, it’s imperative that you receive the experience and advice of an excellent financial adviser and a knowledgeable tax adviser before making this decision.

Nevertheless, the extraordinary tax advantages baked into these oil and gas investments make this an idea to consider for many accredited investors.