The inspiration for today's blog post is some material I am updating for my presentation "Cutting Edge Tax Planning Developments and Opportunities" about tax planning strategies to implement in 2012. As I've found in talking about these strategies over the past few years, most planners are unprepared for the paradigm shift underway as we transition from a flat-or-declining tax rate environment to a rising tax rate environment, which takes traditional strategies (like capital loss harvesting) and turns them upside down.
Most planners are familiar with the capital loss harvesting strategy. The client sells an investment that has a loss (current value is less than the cost basis). By realizing the decline in economic value in a sale transaction, the client receives a tax deduction in the form of a capital loss, that can be used to offset any capital gains. To restrict taxpayers from simply claiming tax losses any time they want, Congress implemented the "wash sale" rules that deny the loss if the client buys the same (or a "substantially identical") security within 30 days before or after the sale. As a result, clients who want to harvest losses must sell the security that has declined in value, and either sit on the sidelines for 30 days (e.g., with the sales proceeds in cash) and then buy the security back a month later, or may buy some other similar (but not substantially identical) security (for instance, by selling Merck and buying Pfizer) for 30 days and then switching back to the original holding (selling Pfizer and buying back Merck again).
The value of a harvested loss is the opportunity to offset a
capital gain, at whatever tax rate would apply to the capital gain. However, by
selling the security at a loss and later buying it back, the client resets the
cost basis to the new, lower amount; as a result, if/when the security
recovers, the client will have a future gain equal to the prior loss.
Consequently, the true value to harvesting losses is attributable to the time
value of money - for instance, claiming a $20,000 loss today (and reducing
current taxes), in exchange for reporting a $20,000 gain in the future
(increasing future taxes), because the client gets to keep/invest/use the tax
savings in the meantime.
Example 1. John sells
his ABC stock, which he originally purchased for $100,000, but is now worth
$80,000. As a result, he realizes a $20,000 capital loss, which results in a
$3,000 tax savings when offset against his other 15% long-term capital gains.
However, when John buys the stock back after 30 days (avoiding the wash sale
rules), his cost basis is now $80,000 (assuming no price change in the interim). As a result, if/when the stock
eventually recovers back to $100,000, John has to realize a $20,000 long-term
capital gain, resulting in $3,000 of additional taxes. In the end, John saved
$3,000 in taxes with the loss, and created $3,000 in future taxes with the gain
created as a result of harvesting the loss. The advantage, though, is that in
the meantime, the $3,000 was in John's pocket to save/invest/use.
This planning strategy works fine in environments where tax
rates are stable - where the tax savings from the $20,000 capital loss match up
with the extra future taxes due from the $20,000 capital gain that comes down
the road. However, in a rising tax rate environment - such as the one clients
current face, where long-term capital gains rates are scheduled to rise from
15% to 20% in just 10 months - a different result emerges. Now the future taxes
from harvesting loss exceed the savings it created!
Example 2. Continuing
the prior example, by the time John sells his ABC stock after recovering, it is
2013, and the long-term capital gains tax rate has risen to 20%. Consequently,
although John enjoyed $3,000 of tax savings by harvesting the original loss, he
now faces a tax liability of $20,000 (gain) x 20% (new capital gains rate) =
$4,000 in the future! As a result, he's actually LOST $1,000 of economic value
by harvesting the loss! In fact, John would need his investments to rally a
whopping 33% for his current $3,000 in tax savings to equal the $4,000 in
future taxes he'll owe, in as little as 10 months! (Or in reality, John would
need a 41.7% return so that his $3,000 of current tax savings would be worth $4,000
in the future, after paying taxes on that appreciation, too.)
To say the least, it can be very risky to speculate on such
a dramatic increase in prices in such a short time period, and as a result,
there is substantial risk to harvesting capital losses in the current tax
environment. However, while John faces an economic loss by harvesting capital
losses right before tax rates rise, the opposite is true if John harvests a gain instead.
Example 3. Continuing
the prior example, assume instead that John sells XYZ stock, which he
originally purchased for $100,000, but which is now worth $120,000. As a
result, John faces a current tax liability of $20,000 x 15% = $3,000. However,
as a result of this transaction, John's
cost basis increases to the current price of $120,000 when he buys the stock
back. Consequently, if John ultimately sells the stock for $120,000 in 2013 or
beyond, he will have only paid $3,000 in taxes, instead of the $4,000 he would
have owed down the road. In other words, John saved $1,000 in taxes by
harvesting the gain, just as he would have cost himself $1,000 in taxes by
harvesting the loss! Even if the stock declines in the future, John's cost
basis is $120,000, allowing him to utilize a bigger capital loss in 2013 and
beyond - which, again, is a "more valuable" loss because it will
apply against higher future tax rates!
Fortunately, harvesting a gain is also much easier than
harvesting a loss. While the tax code has the "wash sale"
restrictions that prevent a client from selling a security for a loss and
buying it back immediately, there is no such restriction on recognizing a gain for tax purposes. The client can
sell the security, recognize the gain, and buy the security back immediately thereafter. The gain is still reported - at current tax rates - and the cost
basis is still increased to the new buyback price - resulting in smaller future
gains or bigger future losses, to be applied against higher future tax rates!
In addition, the strategy is even more effective for clients
with low taxable income, whether they are low income because their portfolios are more modest, or
simply because they are retired and generate little currently taxable income.
For clients whose capital gains fall within the bottom two tax brackets (up to
$70,700 of taxable income after deductions for married couples, or $35,350 for
singles), the long-term capital gains tax rate is 0%! Which means the client
can take a security with a cost basis of $100,000, sell it for $120,000, report
a $20,000 capital gain with a tax rate of 0%, and buy back the security for a
new cost basis of $120,000! The client gets the equivalent of a free step-up in
basis at death, and doesn't even have to die first! (Similarly, advisors should
be very cautious not to harvest
capital losses for clients who face 0% capital gains tax rates, as the client
gets a tax benefit of $0 for harvesting the loss, but resets cost basis lower,
potentially creating a higher tax bill in the future if/when/as rates rise!)
Unfortunately, clients who have significant existing capital
loss carryforwards cannot take advantage of this opportunity, as any harvested
capital gains must be applied against
existing capital losses; in such scenarios, the client may as well just keep
the capital loss carryforwards for the future, and hope to apply them directly
against the higher future tax rates, rather than absorbing the loss
carryforwards at today's low rates.
In some cases, it may still be unappealing to harvest
capital gains. Clients who intend to hold their investment positions until
death - when they will receive a step-up in basis anyway - may not need to
harvest capital gains. Clients with significant capital loss carryforwards may
be unable to harvest gains to pay at today's rates, because of the automatic
offset against losses. Notably, clients in lower tax brackets must also be
cautious, as while the tax rate on
capital gains may be 0%, the gains are still counted in income, which may
impact the deductibility of medical expenses or miscellaneous itemized
deductions, or the taxability of Social Security benefits (although in
practice, even with these adjustments, the client's tax rate may still be no
more than just a few percent, making capital gains harvesting still appealing).
In the end, the current rising tax rate environment presents
a unique opportunity for clients, with both the scheduled lapse of current capital gains tax rates and the onset of the 3.8% Medicare unearned income tax. In such a world, traditional tax planning is turned
upside down... and as a result, for 2012, the greatest value may come not from
harvesting capital losses against today's
low tax rates, but harvesting capital gains to deliberately pay taxes at today's low rates - and in the process,
resetting cost basis higher to reduce future tax liabilities at even higher
So what do you think? Are you considering any capital gain harvesting for clients in 2012? Have you done any gains harvesting in the past? How do your clients feel about paying more in taxes now, if it means they ultimately pay less in the long run? Do any of your clients planning for tax rates to not rise in the future?