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By Aron Szapiro and Jeremy Glaser | 11-17-2017 11:00 AM

Could Tax Reform Boost Capital Gains Distributions?

A provision in the Senate’s bill limits fund managers’ ability to use specific share identification, which could lead to higher distributions.

Jeremy Glaser: For Morningstar I'm Jeremy Glaser. The (House) passed its version of the tax bill, but we're far from the finish line. I'm here today with Aron Szapiro. He's our director of policy research, to look at what's next. 

Aron, thanks for joining me.

Aron Szapiro: Thanks so much for having me.

Glaser: Let's turn to the Senate. That's where the action really is right now. There seems to be a lot of back and forth, trying to figure out what that bill is going to look like. What are some of the pressure points that you're seeing between the senators?

Szapiro: I think the key pressure point here is the reintroduction of healthcare politics into the tax bill. One of the provisions is a repeal of the mandate, the tax that requires people to buy individual insurance. And that seems around $318 billion over 10 years. Now you might be asking, how does repealing a tax save money? The answer is that the assumption is fewer people will go out, buy insurance, which has a federal subsidy for the premiums. We know healthcare politics have been very difficult. This really does sort of amount to a repeal without replace, sort of like the skinny repeal effort that failed a few months ago. As a result, we're seeing some real pushback. In fact, just a few minutes ago, Sen. Murkowski said she was uncomfortable with this provision until there's been some action taken to stabilize the individual market. I think that's one big pressure point.

The other thing that kind of hangs over this entire effort is the reconciliation mechanism they're using. This is a procedure by which the Senate can pass things with a simple majority as opposed to 60 votes to get over a filibuster. That mechanism really was never designed for doing big things. It's probably better suited to a tax bill than maybe other purposes, but there are a lot of rules and a lot of baggage that come along with that, and that's creating a lot of issues for them as well.

And then the third thing that you don't hear as much about, but I think it's quite important, are the so called PAYGO rules. These are rules that date back to I think 1990 with the Budget Control Act, and were substantially revised in 2010. They could create immediate cuts to mandatory programs such as Medicare if they go forward with the current $1.5 trillion increase to the deficit as sort of built in to these tax cuts.

Those are the three big pressure points that I see. And then the fact is the Senate and the House, those are quite different from each other. Just sort of the normal reconciliation and the general sense of these two bills, it's going to be a challenge.

Glaser: Let's talk about one of those differences between the two bills, which is this idea of pass-through income and how that's treated. Can you talk a little bit about where we stand on that front?

Szapiro: Sure absolutely. They're really quite different in this regard, except with the sort of high level assumption that what we want to do as policy is create new rules for pass-through businesses. These are businesses where operating profits flow directly to owners, and pay ordinary income taxes right now on those profits as opposed to corporations that retain earnings to reinvest them and then pay people out of those earnings. But they're very different approaches. The House bill starts with a maximum 25% rate on passive income, and then creates this very complex blended rate for people who are active owners, that is people who are getting pass-through income right now but are actively doing things in their businesses. I think it's important to keep in mind, there are a lot of questions around the definitions of what would be active ownership that would probably end up being sorted out in regulations and maybe in the courts over time, so when you try to come up with concrete answers to some of the subtle questions it's a little difficult. But that's the House approach.

The Senate bill is simpler. It just lets people with pass-through businesses deduct 17.4% of their income.Both bills are designed to make less dramatic changes for professional services firms like lawyers, broker/dealers, actuarial firms, architects, etc., who would be ineligible for the lower rates in the House bill and would see their benefits phased out in the Senate bill.

Glaser: Let's look at some provisions that could impact investors more directly. Can you talk about some of those that maybe haven't been as much in the headlines?

Szapiro: One thing that's sort of interesting here, and it's in the Senate bill, so we have the Joint Committee on Taxation Summary. We don't have specific language. It's this little section called Cost Basis of Specified Securities Determined Without Regard to Identification, which sounds boring and maybe it's designed to sound boring. But what it would do is it would require investors to use a first in, first out basis. What this means in a nutshell, is that most of the kind of tax loss harvesting strategies that exist right now, you wouldn't be able to implement those anymore. You wouldn't be able to cherry pick certain assets to sell or buy to offset others. This could be a problem for investors trying to manage their taxes, and would probably mean that mutual funds would pass through more capital gains to their shareholders.

As I said, we just had the sort of summary of that right now, but one potential downstream effect would be that it would put active funds at maybe a stronger disadvantage on an after-tax basis than they already were. One thing I always like to remind people about this is we're really talking about changing when taxes are realized, not the ultimate taxes, so all these tax loss harvesting strategies do change your cost basis as well, so they kind of change what tax you would owe now and then change what tax you'd owe in the future. If capital gains rates were to change in the future, it's not all that clear these are necessarily the sort of net best strategy, but they're very popular and they reduce taxes today, and this would go right after that.

Glaser: Another area that I know investors are keenly interested in is the mortgage interest deduction. A lot of people own a home. That's not in the Senate version of the bill but you think there still could be an impact on home ownership or home values there.

Szapiro: I actually think that there was a strategy here. I don't mean to be conspiratorial or anything, but this whole thing around the House bill would have capped the mortgage interest deduction at $500,000. The Senate bill keeps that cap where it currently is at a million dollars. I think that is to some extent a red herring. I mean here's where the real action is. What they've done is they've doubled the standard deduction and taken away most, or all in the Senate, the state of local deductions and most of them in the House bill. And what that does is it reduces the number of people who can itemize and who could therefore benefit from mortgage interest deduction from a little over 30% of taxpayers down to 10% of taxpayers. That's really where the action is. It's sort of a backdoor way of getting rid of the mortgage interest deduction.

Now you say to yourself, "OK great. But aren't I still just as well off? I mean my standard deduction doubled, and you know it's fine." Well, the thing is, when they doubled the standard deduction, they also take away the personal exemptions. You're sort of more or less held harmless. It depends on the size of your family and then there's a new child tax credit and all this other sort of moving parts, but basically people who don't itemize are more or less held harmless, and people who do are no longer able to itemize. I think that this has really kind of been ignored, in part because the media was really focused on this $500,000 cap or million dollar cap, but this kind of backdoor way of phasing out the mortgage interest deduction is very much alive and well, and squarely in both versions of the bill.

Glaser: Aron thanks for the update and we'll continue to keep a close eye on this.

Szapiro: Thanks so much.

Glaser: For Morningstar I'm Jeremy Glaser. Thanks for watching.

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