Wednesday, March 14. 2012
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 rates.
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?
On October 3, 2008, then-President Bush signed into law the Emergency Economic Stabilization Act of 2008. Although it was widely known as the "bailout" bill - it was the legislation that authorized the Treasury Secretary to use $700
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Although the tax laws have technically always required that, when investments are sold, the specific lots and their associated cost basis are identified to determine the amount of any gains or losses, in practice most clients have simply chosen after the
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Traditional tax planning for portfolios has been relatively straightforward - given that the same maximum capital gains tax rate applied regardless of whether someone had $100,000 or $1,000,000 of income, the dominant strategy was simply to defer capital
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Too many people think it's always better to defer income taxes to the future, but that's definitely not always the case as your article discusses. Also, anybody planning for tax rates to NOT rise in the near future is taking a huge risk because of the massive financial problems our country has -- due, in part, to the low tax rates of the past few years.
Thanks for the feedback.
In practice, I find the conversations are different, depending on whether we're talking about a client in the 10%/15% brackets, or the higher brackets.
For clients in the lower tax brackets, it's not really a discussion of "pay taxes now vs later" but "get a step up in basis without any taxes at all right now, because your tax rate is 0%!" (With, of course, the caveats of phaseouts and state taxation.) The fact that the net impact is $0 - or at least, close to $0 - generally makes this an easier decision.
The greater challenge is for clients who are in the higher brackets, who really will pay a non-trivial tax liability now - albeit still lower than what the tax rate might be in the future. For such clients, the conversation tends to focus more on what the likely holding period would have been anyway, and how far the stock would need to rise to make deferring still worthwhile.
So, I think that the debate has to be "what is the rate of return to use to analyze this move?" I would think it to be closer to a risk-free rate and not 8%. At 5%, the breakeven point is somewhere in year 12. Might as well look at life-expectancy tables and expect a stepped up basis upon death.
I'm not sure I follow.
The lower the rate of return, the BETTER it is to harvest capital gains. The break even represents the time/return required to make deferral a good deal.
If your returns are low and the breakeven is long, the pressure is overwhelming to harvest unless you're absolutely certain you have a multi-decade holding period (which in practice seems unrealistic for most investors).
Strictly speaking, I suppose anything is "possible" as Congress can write the rules as they wish.
That being said, there has been absolutely no proposal for the kind of limitation you are suggesting here, nor is there any historical precedent for such a restriction.
In addition, a limitation on losses to current rates in the future still doesn't necessarily change the value of harvesting gains at current rates, which are still scheduled to rise. In other words, a limitation on future losses at current rates doesn't make gains harvesting less valuable, it just makes loss deferral not helpful.
I hope that helps a little?
Does the IRS specifically define " immediately "? Can it be 30 seconds later, assuming a liquid publicly traded security? (Like IBM or Apple)
Can you identify IRS rule number?
There is no rule number for this. The fact that a sale triggers tax consequences, and a purchase establishes new tax basis, is standard to the tax code.
The exception is only when there is an explicit rule that PREVENTS such a result - which is the case with wash sales under IRC Section 1091. However, that section explicitly states it applies to losses (and not gains).
Can recognizing the capital gains in 2012 still make sense?
With carryforward losses, there is no capital gains harvesting option - losses MUST be offset against gains, which isn't very helpful given that the gains were going to be taxed at 0% anyway.
In most of these scenarios, we would simply continue to hold the carryforward losses, and use it in the future when it may have more value (against potentially higher tax rates). The primary exception is that if there are a LOT of gains to take, it might still make sense to harvest - for instance, if there's $50,000 of gains, it may be worth absorbing $20,000 of losses to ALSO get the last $30,000 of gains at 0% rates. But that's only useful in scenarios where the gains far outsize the losses.
I hope that helps a little!
To the extent your $5,626 of capital losses couldn't be used for 2011, they would all be carried forward to 2012. Whether they can be used in 2012 will depend on the gains and other income you have for 2012.
I would balance that strategy off against the declined value in real dollars, over time, of the carryforward loss.