Reflection No. 46

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Top of the morning to ya! This week on Reasoned Reflections, we’re diving into an article that explores the potential to eliminate capital gains tax on the sale of your primary residence. We’re also taking a closer look at Section 422 of the Tax Code, which deals with Incentive Stock Options (ISOs) and how they’re taxed.

Three Quick Hits:

• Article: Gain Exclusion on the Sale of Your House

  Complete gain exclusion on the sale of your primary residence might not sound groundbreaking at first. After all, Section 121 of the Tax Code already allows taxpayers to exclude up to $250,000 in gains if filing single or $500,000 if married filing jointly. But here’s the catch: those limits haven’t been adjusted for inflation, and in many markets, home values have increased well beyond those thresholds. For homeowners sitting on large unrealized gains, removing the cap could offer meaningful tax relief. Whether this change becomes law remains to be seen, but it’s definitely one to watch.

• Tip: Set up an automatic split of your paycheck to have a fixed percentage sent to a separate bank account used for investing, saving, or paying down debt.

• Quote: “Don’t let making a living prevent you from making a life.” - John Wooden

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Two Questions:

• What small financial habit (under 5 minutes a day) could you commit to that would benefit your future?

• What’s one recurring expense you pay for out of habit but rarely use?

REFLECTION No. 46: Incentive Stock Options

I - Issue: What’s an incentive stock option (ISO)?

R - Rule: An ISO is a type of equity compensation granted by private companies that allows employees to purchase company stock at a fixed price. Section 422 of the Tax Code provides favorable tax treatment for ISOs if certain holding requirements are met.

A - Analysis: ISOs give employees the option to buy shares at a preset strike price, but they don’t actually own any shares until they exercise those options. The big tax perk? Unlike nonqualified stock options (NSOs), ISOs aren’t taxed at exercise…at least not for ordinary income tax purposes.

Instead, if the employee holds the shares for 1 year after exercise and 2 years after the grant date, any gain is taxed at the long-term capital gains rate (typically 20%) instead of ordinary income rates (up to 37%). That’s potentially a 17% tax savings. However, the spread at exercise may trigger AMT liability, so careful planning matters—especially when exercising large blocks of options with an exponential increase in the value of the company’s common stock.

In short:

A. No ordinary income tax at exercise (unlike NSOs).

B. Capital gains treatment if held >1 year post-exercise and >2 years post-grant.

C. Watch out for AMT if the spread between strike price and fair market value is large.

Lastly, if you don’t meet the holding periods, well, then you’re back to being taxed at ordinary income rates.

C - Conclusion: ISOs offer a valuable tax advantage for startup employees but only if you understand the timing rules and plan your exercises wisely. Section 422 rewards long-term thinking.