In the Face of Rising Capital Gains Tax Rates

No one should be surprised if federal tax rates on capital gains increase in 2009…even though Congress just recently extended the current 15% rate on capital gains and qualified dividends to 2010. Political pundits and economists seem to agree that no matter which party wins the White House later this year, so long as Democrats remain in control of both houses of Congress, some tax bill will be one of the first orders of business. Some commentators even think that tax increases would be wise. In any event, exactly when this would go into effect, and how rates for individual tax payers will be affected are details still unknown. However, it’s not too early to begin to consider circumstances that might justify accelerating the sale or gift of highly-appreciated assets, this year, before they may be subject to higher capital gains tax rates in 2009.

There are at least a couple of cases where the answer to the acceleration question is probably “no”. First, where the assets aren’t needed for the current “senior” generation and will receive a basis step-up when passed to the next generations. Assuming, of course, that full basis step-up continues to be the prevailing regime. While a Democratic Congress almost certainly won’t “repeal” the estate tax outright, as many Republicans want, some “death tax/income tax” compromise is possible and complete basis step-up could disappear. And second, where the assets are earmarked for future gifts to charity. In both of these cases, voluntary realization of capital gains this year is simply unnecessary.

For many other cases, the conclusions aren’t so clear. For example, portfolio rebalancing, moving to new investment opportunities and/or preferred managers, replenishment or expansion of cash reserves, and reducing concentration risk of a single security could argue for taking action sooner rather than later.

Determining whether accelerating capital gains makes sense requires exploration of the impact of several variables: the level of potential tax rate increases, size of the asset’s embedded gain, expected future investment return…and, especially, the anticipated future investment timeframe. The longer you would expect to hold the asset, the less it makes sense to sell it now.

In the case studies below, we will share general insights and present case studies to demonstrate how these insights can be applied to help frame specific decision making. Should one of these examples raise a question about your own situation, please contact your client service team to discuss it in more detail. We, of course, look forward to assisting you on these and other important matters in the coming year.

Scenario Planning

Our analyses compare the results of two different actions: accelerate sale at today’s low capital gains tax rates, reinvest the after-tax proceeds in the same asset, and then sell again at some point in the future vs. continue to hold the asset now but then selling at that same future point, but at higher tax rates at that time. Future tax rates will be what they will be, but you can invoke today’s known tax rates on the gains that currently exist. This comes at the cost, however, of taking that current tax liability out of the game as well as incurring the transactions costs of selling (early) and buying back. So, again, if you would be holding for a long time in any event, the lost opportunity on that current tax (and transaction expense) becomes a larger and larger cost.

Based on conversations with commentators at Stanford Policy Research, here are some possible tax rate scenarios.

Best Case: In the politically unlikely event that the current tax rates would be allowed to just expire at the end of 2010, the federal long-term capital gains top rate increases automatically from the current 15% to 20%. Knowing that a Democratic Congress could force this on the White House by simply doing nothing, a Republican administration might need to compromise with a Democratic Congress on other matters and allow this top rate to increase even sooner. Consequently, we think 20% is the low end of the range of possibly higher rates.

Worst Case: Another argument says top rates could go as high as 28% should the Democrats – with a platform of new government spending (e.g., on health care) and higher taxes on the wealthy - be in firm control of Congress and the White House. We thus use 28% as the high end of our range of possible capital gains rates.

General Conclusions

The diagram below attempts to summarize the general conclusions about the impact of key variables on the decision to accelerate or not.

Unexpectedly, the cost basis of the asset does not change the calculated break-even holding period. The cost of the current tax over that time frame exactly offsets the benefit of avoiding the future, higher tax on that current gain. It will, however, effect the cost of error. If your holding period turns out to be longer, in fact, than you anticipated, sales now of low basis holdings will be more costly than sales of high basis assets.

Time-Frame Breakeven Points:

For a given investment return assumption, you can calculate a specific time frame at which you are indifferent to selling now, rebuying, and selling later, or just continuing to hold. The table below assumes an 8% pre-tax return for the asset under consideration. If your expected rate of return for the asset is greater, the break-even time frame is shorter (due to greater opportunity cost on the current tax amount). If the return expectation is lower, the break-even time frame is longer. This tax optimization nicely coincides with what may be the investment optimization of the portfolio. A low returning asset is a more attractive candidate for the initial sale, for tax reasons alone, since the break-even time is longer. To optimize the investment return, maybe the proceeds should be used to invest in something else.

On that 8% return assumption (again, regardless of basis!) you should sell assets in 2008 if your holding period is anticipated to be less than the breakeven listed in the chart below. In all cases, if your holding period is expected to be more than 10.3 years, it is unlikely an accelerated sale of assets is warranted.

So, a California tax payer who expects tax rates to increase to at least 20% and would expect to sell within three years in any event should sell now.

These perhaps surprisingly shorter break-even periods, when a large state tax is taken into account, result from the smaller relative changes: a 5% increase in rates is a larger change on federal rates alone than it is on the combination of federal rates and already high California rates. Said another way, Nevada residents would experience a greater relative change than California residents and, everything else equal, would be wiser to sell now.

Example 1: Gifts to family members

In most circumstances, we advise our clients to give either cash gifts to family members…or to give appreciated assets in vehicles (see the article on Defective Grantor Trusts) that retain the donor’s income tax liability…in order to avoid pushing the tax liability to the recipient. Should you be contemplating making such a gift in the next several years, and would be selling appreciated assets to raise the cash or to liquify the trust asset, it may make sense to do that sale in 2008.

Example 2: Sale of a concentrated position

If you are holding a highly-appreciated, concentrated position in an individual security, 2008 is a good year to revisit your plans. Everything else equal, 2008 will likely be a better year to get on with diversification plans than to continue to wait. Viewed another way, this is an example of a very short anticipated time frame. If the position should be diversified in any event, the anticipated time frame for holding it should be zero!

Example 3: Replenishment and/or expansion of cash holdings

Some of our clients, especially retirees, hold substantial cash reserves, which we replenish periodically. Following 5 years of strong equity returns, 2008 may be a good year to replenish these reserves at a lower tax cost than may apply in 2009 and beyond.

Example 4: One-time, opportunistic rebalancing

If a relatively significant infusion of new, tax deferred assets is expected in the portfolio in 2009 (for example, due to retirement), it’s possible we should rebalance some of the taxable assets this year, if the optimization of the overall investment portfolio can’t be accomplished solely through movement in the tax deferred assets. For example, where the tax deferred account’s existing investment choices have been extremely limited or are sub-optimized from a location perspective (e.g., the tax deferred account currently holds relatively tax-efficient assets while tax-inefficient assets reside in the taxable accounts).

Example 5: Ongoing rebalancing and manager changes

As we near the end of a tax year, we typically delay ongoing portfolio rebalancing and manager changes that would result in the recognition of capital gains in the current tax year, in order to push the tax cost to the following tax year. Ten or eleven months from now, as we near the end of 2008 and face higher tax rates (by then, we’ll probably have a much better idea of whether and by how much than we do now), we may actually decide to accelerate such moves in order to lower the tax cost of doing so.

Linda Fitz and Karen Blodgett, San Francisco