Tax Planning for Realized Gains and Ordinary Income

‍Why is tax planning important?

Tax planning helps you keep more of your hard-earned gains by reducing your applicable taxes. Unfortunately, most people are unaware of how impactful tax planning could be and that it could boost their investment returns by 40% or more! The goal of tax planning is to make sure there is tax efficiency and it should be essential for anyone´s financial plans, but what exactly is it?

Tax planning is the process of analyzing and preparing a financial plan or a situation from a tax perspective that helps you to legally minimize how much you pay in taxes to help you keep more of your earned money, both for your use over time and to build your wealth for the long term.

How does Valur come in?

We know there’s nothing simple about taxes, so Valur is here to help by taking the sophisticated tax planning and asset protection tools of the ultra-rich and making them seamless and accessible to everyone.

If you have received a large amount of income from selling an asset or just received a lot of income this year, Valur can help you set up the right tax planning structure for you. (Even if you’re still holding your assets and you’ve got a big gain coming, please check out our Unrealized Income Guide for details of this scenario)

In this guide, we’ll focus on the characteristics of three different structures commonly used for these situations, and we’ll also use an example to help you understand the benefits and the tradeoffs of each one.

Realized Income

Realized income is the appreciation that you receive as a result of a sale of any financial asset or from your salary. Critically, when you realize income you are subject to taxes.

On the other hand, unrealized gains are the potential profit (current price – the price you bought the asset at) that you would gain from selling any investment.

Tax strategies for realized gains

There are three key tax savings opportunities for realized income and salary that can help you reduce the taxes:

• Tax credits
• Deductions
• Depreciation

A tax credit is a dollar-for-dollar reduction in the amount of taxes you owe. For example, say you have $100,000 of income and owe $25,000 in taxes. If you then received a $5,000 tax credit, your tax liability would be reduced to $20,000, and you would take home that extra $5,000.

Tax credits directly reduce the amount of taxes you owe and in a sense are similar to a gift card or store credit you can use to reduce your tax bill. Over the last few years tax credits have become an increasingly popular tax mitigation tool due to increasing incentives tied to renewable energy incentives. In particular, the solar infrastructure credits in the 2022 Inflation Reduction Act are a particularly attractive opportunity to reduce your income tax. Read more about the IRA’s investment tax credits.

A tax deduction is another way to reduce taxable income, this time by reducing the income that is subject to taxation, thereby indirectly reducing the amount of taxes you owe. Contrast this with tax credits, which directly reduce the amount of taxes you have to pay.

Like tax credits, deductions are very common in the code. The most common is probably the deduction for charitable donations; by donating to a qualified charity, you can reduce your taxable income and thus your taxes. Some examples are Donating to Donor Advised Funds (DAF) and Setting up a Charitable Lead Annuity Trust (CLAT), both of which we’ll explain more in detail below.

Depreciation is the amount of value that a physical asset loses over time. When you drive your new car off the lot and its value drops immediately, or when a piece of machinery becomes less valuable due to wear and tear, that’s depreciation. From a tax standpoint, depreciation is relevant because you may be able to take a deduction for some or all of the amount of the value an asset loses over time, reducing your taxable income and saving money on your taxes.

Depreciation arises less often for wage earners than other deductions and tax credits, for the simple reason that this is typically not a deduction that you are allowed to take against wage income. Instead, depreciation usually arises if you have a business or own a rental property; business owners are allowed to deduct the depreciation on their business’s assets, like office furniture, electronics, and vehicles, and landlords may deduct the depreciation on the property they rent out.

Next, we are going to walk through a few popular tax planning structures used for realized gains:

• Grantor Charitable Lead Annuity Trusts (CLATs)
• Opportunity Zones
• Donor-Advised Funds

Grantor Charitable Lead Annuity Trusts

CLATs are tax-exempt accounts that can earn you additional returns of 50% or more even if you’ve already sold your assets.

With a CLAT, you can:

1. Reduce your taxable income now: With a CLAT you can reduce your taxable income now, defer your tax bill for the future and reinvest those tax savings but you limit your access to the assets for a number of year
2. Use your money to make the same investments you would make if you had a regular taxable account.

With Grantor CLATs you gift assets to the trust and in exchange can receive a charitable deduction of up to 100% of your assets value to reduce your income that year. Every year, the trust gives a donation to charity and then you receive the remainder after that final contribution.

An important trade off for CLATs is that the money is locked away for the entirety of the trust’s term, much like a retirement savings account or IRA. At the same time, you are responsible for the taxes on the trust’s income, so this means that you may have to pay taxes on that income out of pocket each year. But this shouldn’t be a huge concern, as the amounts we’re talking about are small.

You can choose the length of your trust. Typically people set up CLATs for a minimum of 15- or 20-years to take advantage of the compounding tax mitigation benefits (depending, of course, on your assets, how quickly you expect your money to grow, and other details).

Interested in learning more about these structures? Visit our article where we explain how they work and in what sorts of situations they might prove valuable and check out your own potential tax savings with our online calculator.

In this video, Valur.s CEO, Mani Mahadevan, explains in-depth how to save more money with our tax planning strategies. Check it out!

Opportunity Zones

Opportunity Zones are an economic development tool that allows you to invest in distressed areas in the United States and gain tax benefits.

Investments in Opportunity Zones are eligible for preferential tax treatment if they are made through a Qualified Opportunity Fund (QOF), which is an official designation for investment vehicles that commit to investing 90% or more of its assets in Qualified Opportunity Zones.

These structures can be a good fit if you have already realized a big capital gain. If you roll your eligible realized capital into a Qualified Opportunity Fund within 180 days of realizing the gain, two forms of tax incentive are available:

Capital gains rolled into a QOF may be deferred until the investment is sold or exchanged, or the end of 2026, whichever comes earlier.

You can save even more through an adjustment in cost basis of your investment. If you hold the QOF investment for at least 10 years, you can avoid taxes entirely on the sale of the Opportunity Zone investment.

The main downsides of Opportunity Zones include the following:

1. High fees vs more traditional investments (typically at least 1.5% annually)
2. A long period of illiquidity: money has to stay in a QOF for at least five years from the fund close to realize the tax reduction benefits and ten years from the fund close to realize the basis adjustment benefit.
3. Exposure to concentrated assets.
4. Uncertain returns: We don’t have historical returns for QOFs as they were only created by law in 2017

If you’d like to read more about Opportunity Zones, please visit our blog post on this topic here.

Donor-advised Funds

A Donor-advised Fund (DAF) is a giving account established at a public charity; it exists for the purpose of supporting charitable organizations, by offsetting or eliminating a big tax bill while retaining flexibility in timing and recipient of donations.

Donors can contribute to the fund as frequently as they like, and then recommend grants to their favorite charitable organizations whenever it makes sense for them.

The main benefits of DAFs are:

1. Eligibility to take an immediate tax deduction when you contribute cash, stocks or non-publicly traded assets such as private business interests, cryptocurrency and private company stocks, just as if you had donated the funds directly to a charity.
2. Versatility: these structures allow you to give when, what, how, and where is most favorable for yourself. You have the chance to contribute immediately, build a philanthropic strategy and donate when you’re ready.
3. Possibility to invest the funds, they’ll grow and you can give the additional gains to charity in the future, tax free.

Downsides include the following:

1. Donations are irrevocable: the funds cannot be returned to the donor or any other individual or used for any purpose other than grant making to charities.
2. DAFs may have some minimum donation requirements
3. You don’t receive any of the donated assets back (or share in any financial upside from the investments)

Charitable Lead Trusts vs. Opportunity Zones vs. Donor-Advised Funds

As you might guess, each structure has its own set of positive and negative trade-offs. Choosing which structure to use is a personal decision that depends on your family circumstances, your financial goals, and what you want your life to look like for the next years.

Below, we’ll compare each across several useful metrics, including, most importantly, the bottom line: how much you’ll earn over your lifetime using each.

Comparing the Return on Investment (ROI) of each structure:

We understand that this can be a lot to digest, and while the qualitative trade-offs above are important, it’ll be helpful to walk through an example to see the ROI of each structure.

Let’s assume a time lapse of 10 years (Any payouts that might happen after 10 years are discounted by the time value of money to calculate their net present value in 10 years)

Like a lot of our Customers, Sara is 35 years old, based in California, with $1m of appreciated assets at a $0 cost basis. She expects a 35% tax rate (assuming long-term capital gains tax rates) and for the stock market to grow 10% annually, while an opportunity zone investment would appreciate 9% annually (after fees).

The order of returns by strategy would be as follows:

• Charitable Lead Annuity Trust (30-year term): $1,971,897 – additional 44% return
• Opportunity Zone: $1,828,845 – additional 33% return
• Donor-Advised Fund (DAF): there are no returns; although you will save significantly on this year’s taxes, those savings are more than offset by the donation amount.
• No Tax Planning: $1,373,934 – 0% return

You can also find more detailed information about the three structures and their trade-offs in this article.

In conclusion, Charitable Lead Trusts, Opportunity Zones, and Donor-Advised Funds are all viable options for tax planning, with each offering its own merits.

• While CLATs allow you to reduce your taxes after selling an asset, tend to have high ROI in the long term but have the longest path to liquidity
• Opportunity Zones also have a good ROI, offer more initial liquidity but less diversification than CLATs and they also allow you to reduce your taxes after the fact and in future tax years.
• DAFs instead give charitably inclined individuals the freedom to donate (and take a tax deduction) now without committing funds to a particular charity, and the funds can be invested in the meantime.

There’s no “one size fits all” solution, and the right choice will be depend on your personal preferences and tax position. But don’t worry! Valur is here to help.

Next Steps

If you would like to learn more, please feel free to check out our Learning Center, or schedule a time to chat with us!

Related Readings

• Case Study: Tax Strategy For Realized Gains
• Opportunity Zone Tax Benefits
• CLAT: A Comprehensive Guide

About Valur

We built a platform to give everyone access to the tax and wealth building tools of the ultra-rich like Mark Zuckerberg and Phil Knight. We make it simple and seamless for our customers to take advantage of these hard to access tax advantaged structures so you can build your wealth more efficiently at less than half the cost of competitors. From picking the best strategy to taking care of all the setup and ongoing overhead, we make it easy and have helped create more than $500m in wealth for our customers.