4 Tips for Tax-Efficient Investing

The biggest threat to the average investor’s gains isn’t risk or even a sudden downturn — it’s the tax man.

Whether you barely break even, or make a killing investing in the top dividend-paying stocks, you’ll have to give the IRS a cut. Even your retirement fund is taxed.

Although, with some smart investing, you can minimize your tax exposure. In a world where there’s no such thing as tax-free investing, the best you can hope for is tax-efficient investing. Let’s look at some of the best ways to lower your tax bill.

Traditional IRAs, Roth IRAs, and 401(k) plans can radically reduce your present and future tax liability.

Put money into tax-efficient accounts like IRAs and 401(k) plans

Let’s start with a simple one. Using traditional IRAs, Roth IRAs, and 401(k) plans to save for retirement can radically reduce your present and future tax liability.

Putting money into a traditional IRA is done pre-tax, which reduces your current tax bill. Roth IRA and Roth 401(k) contributions are made post-tax, which means future withdrawals won’t be taxed.

Another way to look at it is that traditional IRA withdrawals will be taxed at your future tax rate, which could be lower than the one you’re paying when you make the contributions. On the other hand, future Roth IRA withdrawals are tax-free, but the contributions have been taxed at your current rate. Deciding which one is more tax-efficient for you is going to depend on your personal earning trajectory, your retirement strategy, and other financial considerations.

Just remember — your annual contributions to each kind of account are capped at a certain amount, so talk to a financial advisor or tax professional when you’re planning your tax strategy.

Hold investments long enough to avoid short-term capital gains

Any investment you hold for a year or less is going to be taxed as short-term capital gains, which are treated like personal income — and can be taxed as high as 37%. However, if you simply hold on to the investment longer than a year, it will be taxed as long-term capital gains, at a rate of 0%, 15%, or 20% depending on your income.

Of course, this may not always be a viable strategy. For example, house flippers often work on razor-thin margins, relying on techniques like home buyer rebates to cut down their initial outlays, and comparative market analyses to nail their list price for a fast sale.

Urgent investments aside, anything you can hold onto long enough to convert to long-term capital gains is going to save you a lot of money.

State 1031 exchange regulations make Colorado one of the safest states to do exchanges

Use a 1031 exchange to defer your capital gains tax bill

Let’s say you bought an investment property a decade ago, and it’s doubled in price over the years. If you sold outright, you’d owe capital gains tax on the appreciated value, which would eat up a sizable chunk of your profits.

A 1031 exchange would allow you to take the proceeds from your initial sale and use them to purchase another like-kind property while deferring capital gains. The best part is that you can use a 1031 exchange repeatedly, upgrading your properties each time until you’ve built a mini real estate empire without paying a cent in capital gains. When you liquidate your holdings, your capital gains taxes will come due, but that could be decades from now — and by then, your net worth will have grown immensely.

A 1031 exchange does have a few pretty strict rules. The exchange has to be executed within a narrow time window (generally 90 days), and the exchange itself has to be handled by a third-party qualified intermediary so you never technically have ownership of both properties.

The rules governing a 1031 exchange vary from state to state. The good news for Colorado investors is that state 1031 regulations make Colorado one of the safest states to do exchanges in, as state law outlines strict financial requirements for qualified intermediaries and how they handle your money.

Use your investment losses to offset your gains

Taxpayers can use up to $3,000 of losses per year to offset their gains. Let’s say your investments gained $5,000 in value last year, but you took a lot of losses, too. You can use $3,000 in losses to reduce your taxable income to only $2,000 — saving you a lot in taxes, especially if some of those profits were short-term capital gains (which are taxed at income tax rates). If you have more than $3,000 in losses in a single year, you can also apply those losses in subsequent years.

Some investors will intentionally sell at a loss — a practice called “tax loss harvesting” — to offset gains that are subject to high tax rates. Before you undertake this strategy, consult with a financial advisor to find out if it makes sense for you. Investing is all about managing risk, and sometimes those hot stock tips don’t work out. But there’s a silver lining to your losses — you can use them to reduce your income tax liability.

Luke Babich is the Co-Founder of Clever Real Estate, a real estate education platform committed to helping home buyers, sellers, and investors make smarter financial decisions. Luke is a licensed real estate agent in the State of Missouri and his research and insights have been featured on BiggerPockets, Inman, the L.A. Times, and more.