Answers ยท Tax Deferred Strategies
Is it legal to defer capital gains tax?
Yes. Putting off tax on a gain is written into the federal tax code, and a 401(k) is the everyday example. What is illegal is evasion, which means hiding income or lying about a sale. In between sits a gray zone of aggressive schemes the IRS can undo. A legal deferral follows a written rule, is set up before the sale is binding, and delays the tax without erasing it.
You are probably deferring tax already, and nobody calls that a loophole.
If you own a 401(k) or an IRA, you have been deferring tax for decades. You skipped the tax on the money going in, and you pay it when the money comes out. Congress wrote that rule on purpose.
A gain on a house, a business or a stock works the same way before you sell. Your house can double in value and you owe nothing until the sale. The tax waits for an event. So the question underneath is narrower: once I sell, can the tax still wait? Sometimes it can, under rules that sit in the code in plain sight.
Quick note on who is talking. opfinances.com is a licensed insurance agency. We are not a financial advisor, not a fiduciary, and not a tax or legal adviser. This is general education, not advice about your sale.
Avoiding tax is legal and evading it is a crime, and the difference is whether you told the truth.
Evasion means hiding income, lying on a return, or pretending a sale did not happen. It is a felony, and people go to prison for it.
Avoidance means arranging a sale so the rules produce a smaller or later bill, and then reporting all of it. A federal appeals court said in 1934 that anyone may arrange their affairs so their taxes are as low as possible, and that nobody has a duty to pick the pattern that pays the Treasury the most. The Supreme Court upheld the ruling the next year.
That case gets quoted in a lot of sales pitches, and the pitch usually leaves out how it ended. The taxpayer lost. She had followed every step the statute listed, but the steps had no purpose except dodging the tax, so the court looked through them. The same case gives you the right and the limit.
A plan can follow the letter of the code and still get thrown out.
That limit is now written law. Since 2010 the tax code has said a transaction has to change your economic position in a real way apart from the tax, and you need a real reason for doing it besides the tax. Fail that test and the tax comes back with a 20 percent penalty on top. The penalty is 40 percent if the transaction was not disclosed on the return.
Two older rules do most of the work in a sale. The first is timing. Once a sale is binding, the gain is treated as yours, and moving the asset somewhere else afterward does not change who owes. The second is control. If the cash is available to you, you are generally taxed as if you took it, whether or not you touch it.
That is why a real deferral usually costs you something, whether it is access to the money, flexibility, or fees. If a plan promises the tax goes away and you still get all the cash on day one with no strings, be suspicious.
California is its own question. The state does not follow every federal rule, and some federal breaks do not exist on a California return at all. A plan that delays the federal tax can leave the state bill due in full.
Deferred means later, and later still arrives.
A deferral moves the bill. It does not delete it. What you get is the use of the money in the meantime. Illustrative arithmetic: put off a 400,000 tax bill and earn 5 percent on that money, and it produces about 20,000 a year you would not otherwise have. That is worth something. But setting the structure up costs money too, and rates could be higher when the bill finally lands.
So a legal deferral can still be a bad deal. Legal tells you that you are allowed. It does not tell you the math works for your sale, and sometimes paying the tax and moving on is the better choice.
The abusive versions look alike, and the IRS publishes the list.
Every year the IRS puts out a list of the tax schemes it is targeting, called the Dirty Dozen. Several entries over the years have been stretched versions of legitimate structures, sold to people with a large sale coming. The same idea can be fine done one way and abusive done another.
The warning signs repeat. The promoter's fee is a percentage of the tax you save. You are told to keep it from your CPA, or that your CPA would not understand it. Nobody independent will put the legal basis in writing. The paperwork is dated after the deal was already agreed.
One more thing about incentives, ours included. We are paid when a client ends up in a product we offer, so check what we say the same way you would check anyone else. Ask for the code section, ask what it costs, and take it to a tax attorney who is not paid by the person selling it.
Before you decide
Questions worth asking.
Which section of the tax code is this built on, and can I read it myself?
Will a tax attorney that I pay, and you do not, put an opinion on it in writing?
What do I give up to get the deferral: access to the money, control over it, or flexibility later?
When does the tax finally come due, and what would trigger it early?
Does California treat this the same way, or will I owe the state in the year of the sale?
How are you paid, and does your fee depend on how much tax I defer?
Related
What is the difference between tax avoidance and tax evasion?
Avoidance is arranging your affairs within the rules so the tax is smaller or later, and reporting everything. Evasion is hiding income or lying about it, and it is a felony. The dividing line is honesty and whether a written rule supports what you did.
Do I still have to pay the tax if I defer it?
Usually yes. A deferral moves the tax to a later year. It does not cancel it. The benefit is having the money working for you in the meantime, and that has to be weighed against what the structure costs.
Can the IRS undo a tax deferral years later?
It can. The IRS generally has three years from the date you file to examine a return, six if more than 25 percent of your income was left off, and no time limit where there is fraud. If a structure is disallowed, you owe the tax plus interest and often penalties.
Does California follow the federal rules on deferring capital gains?
Not always. California taxes capital gains as ordinary income and does not adopt every federal provision, so a structure that delays federal tax may not delay the California tax. Ask about the state return separately.
When does a capital gains deferral have to be set up?
Before the sale becomes binding. Once you have signed, the gain is generally treated as yours, and most options are gone. Some structures take weeks to put in place, so the conversation belongs before a letter of intent or purchase agreement.
Where this fits.
This question sits inside a bigger one. Tax Deferred Strategies walks through the whole decision rather than this one piece of it.
On Point Finances is a licensed insurance agency, not a tax, legal, or investment adviser. This page is general education, not a recommendation, and reading it does not create a client relationship.