Capital gains taxes can take a significant bite out of investment returns. While most people have limited ways to reduce these taxes, the ultra-wealthy often deploy sophisticated, entirely legal strategies to limit or defer them. If you’ve ever wondered how some high-net-worth individuals seem to pay relatively little tax on massive gains, here’s a closer look.
Understand capital gains
Capital gains refer to the profits realized when an asset is sold for more than its original purchase price. There are two types of capital gains: short-term and long-term.
Short-term gains apply to assets held for one year or less and are taxed as ordinary income.
Long-term gains, which apply to assets held for more than a year, are taxed at preferential rates of 0%, 15%, or 20%, depending on your income.
Strategies used to avoid capital gains tax
The ultra-wealthy use many effective strategies to avoid paying capital gains tax. Here are the main ones.
Donating appreciated assets
Rather than selling stocks or real estate and incurring a taxable gain, many wealthy individuals donate appreciated assets directly to charity or a donor-advised fund (DAF).
Here’s why that works:
- They avoid paying capital gains taxes altogether.
- They receive a charitable deduction based on the full fair market value of the asset.
DAFs allow donors to contribute appreciated assets, claim an immediate tax deduction, and recommend grants to charities over time.
Qualified opportunity zones (QOZs)
QOZs were created by the Tax Cuts and Jobs Act of 2017. They offer tax incentives for investments in designated low-income communities.
Here’s how QOZs work:
- Investors can defer capital gains tax until 2026 by reinvesting gains in a qualified opportunity fund.
- If the investment is held for 10 years, any additional gains on the opportunity zone investment may be excluded from taxes.
This is a favored strategy for those looking to redeploy gains while stimulating economic development.
Borrowing against appreciated assets
Rather than selling stock and triggering a taxable event, many ultra-wealthy individuals take out loans using their portfolios as collateral.
This strategy offers several advantages:
- No capital gains tax is incurred because nothing is sold.
- Interest payments may be deductible if the loan is used for investment purposes.
- Cash is made available without reducing exposure to long-term investments.
This strategy is popular with technology founders and others with significant unrealized gains in stock.
Installment sales
Installment sales spread the gain over several years by structuring the sale of an asset in installments.
This technique:
- Defers recognition of gain until payments are received.
- Allows income to be recognized over time, potentially staying within lower tax brackets.
It’s beneficial in selling a business or real estate, where full payment isn’t required upfront.
Charitable remainder trusts (CRTs)
A CRT is an irrevocable trust that allows you to:
- Donate appreciated assets without recognizing immediate capital gains.
- Receive income from the trust for life or a term of years.
- Leave the remaining assets to a charity upon termination of the trust.
This strategy creates a stream of income while minimizing taxes and supporting a charitable mission.
Like-kind exchanges (Section 1031)
Section 1031 of the Internal Revenue Code allows real estate investors to defer capital gains tax when they exchange one investment property for another.
This only applies to business or investment real estate, not personal residences, and requires strict compliance with IRS rules.
The strategy can be repeated multiple times, allowing gains to compound tax-deferred.
Grantor-retained annuity trusts (GRATs)
GRATs are popular estate planning tools that can also reduce exposure to capital gains.
How it works:
- The individual transfers appreciating assets into a GRAT.
- They receive annuity payments for a set term.
- Any appreciation beyond a specific amount passes to heirs free of gift and capital gains tax.
This strategy is particularly effective with assets expected to grow quickly, like technology stocks, renewable energy projects, startups in innovative sectors, real estate in rapidly developing areas, and cryptocurrency investments.
Reset cost basis through inheritance
When someone dies, their heirs generally receive a “step-up” in basis. This means the asset’s cost basis resets to its value on the date of death, potentially eliminating capital gains taxes on prior appreciation.
Ultra-wealthy families often retain appreciated assets rather than selling them to pass them to heirs.
Tax-loss harvesting (strategically)
Tax-loss harvesting is a strategy where investors sell securities at a loss to offset capital gains from other investments, thereby reducing their overall tax liability.
You can offset gains from other investments by selling securities at a loss. Sophisticated investors often:
- Harvest losses across taxable portfolios throughout the year.
- Use algorithms or advisors to monitor portfolios for opportunities.
They may repurchase similar, but not substantially identical, assets to maintain exposure while complying with the IRS wash-sale rule.
Conclusion: It’s about deferral, reduction, and elimination
What separates ultra-wealthy investors from the average taxpayer isn’t just income. It’s access to expert advice and a range of tools that allow them to:
- Reduce exposure to capital gains taxes
- Defer recognition of gains
- Eliminate taxes through strategic timing or charitable giving.
Each of these strategies is legal. But they require meticulous planning, significant assets, and skilled advisors.
