Tactics for Tax-Gain Harvesting This Fall

Christine Benz: Hi. I'm Christine Benz for Morningstar.com.

With capital gains rates set to head up in 2013, many investors are wrestling whether to preemptively harvest capital gains.

Joining me to discuss that topic is Michael Kitces. He is partner and director of research at Pinnacle Advisory Group.

Michael, thank you so much for being here.

Michael Kitces: Thanks, Christine. Great to be here.

Benz: So, Michael, first let's discuss what is set to happen in 2013 with capital gains rates?

Kitces: So, as we're scheduled right now, capital gains rates are set at 15% for people in the upper tax brackets and 0% for those in the bottom two tax brackets. That's scheduled to rise next year with what actually is the lapse of rules that have been around for almost 10 years, and we go back to basically the old rules. The old rules had a top capital gains rate of 20% and a bottom capital gains rate of 10%. So in essence the 15% rates go to 20% and the zeros go to 10%.

Now, the additional overlay we actually have on top of that from the Patient Protection Act is the new Medicare unearned income tax, which is a 3.8% additional tax on, essentially, portfolio income--it’s got a few other things in there, as well--that applies to people with more than $200,000 of AGI or $250,000, as a married couple. So, what we're looking at really becomes three capital gains brackets: a 10% bracket, a 20% bracket, and then a 23.8% bracket for people at the highest income levels.

Benz: OK. So, let's discuss what types of assets would receive this capital gains treatment. It's investment assets, but it's also home-price appreciation as well above a certain level.

Kitces: Absolutely. Ultimately anything that is going to get classified as a capital gain--really a long-term capital gain, so held for more than 12 months--anything that's going to get classified as a long-term capital gain and shows up on your tax return accordingly, is subject to these rates.

So, certainly that's anything we hold in our portfolio. That also can be even things like the sale of our personal residence. Now, the benefit we get for our personal residence is that special gains exclusion that says, the first $250,000 as a single person, or $500,000 to a married couple, of gains is excluded entirely; if it doesn't show up on our income, if it doesn't show up as a capital gain, it's not subject to the old rates or the new rates.

But certainly for some areas … although prices have come down, someone might have bought their house 20-30 years ago, saw a significant appreciation. If we had someone, say, who bought their house originally for $250,000 a long time ago, and it's now worth $1.5 million, and they have $1.25 million of appreciation, $500,000 can come out of that as a married couple, but the remaining $750,000 is actually still subject to capital gains, including the 10% and 20% brackets, including the potential 3.8% surtax.

Benz: OK. And short-term gains still taxed at your ordinary income tax?

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Kitces: Short-term gains still taxed as your ordinary income. That also rises as the ordinary income brackets are set to rise under its own schedule.

Benz: One thing I've been hearing from a lot of our Morningstar.com users is that they have been thinking about preemptively selling things that they wanted to lighten up on anyway, and to me that seems like a no-brainer. We don't know for sure that currently low capital gains rates will change and go higher, but if you wanted to sell something anyway, you might as well unload it. Do you agree with that?

Kitces: Yes. And we've seen a lot of that activity under way. So, the challenge for rising rates, in essence, is, if I've got this looming capital gain--I bought something, it's actually appreciated in value, how wonderful--I'm kind of afraid to get out of it because I know the reality is whenever I sell it, I'm going to owe some taxes. Waiting until next year with a higher tax rate structure just literally means you're going to pay out more tax dollars for the same gain. It's an economic loss.

So, for anybody who is looking at possibly selling an investment position anyway, we've seen a lot of people step up their activity on that and say, well, I was thinking about selling anyways or making a change--whether that was going from stocks to bonds or cash or something else or simply going from stock A to stock B or fund A to fund B--if there was a change that might have happened anyways and maybe paying taxes was a little bit of an inhibitor, rising tax rates should maybe make that a little bit more encouraging to say well, it's really not going to get better. If you wait it could actually get worse.

Benz: And the wash-sales rules that apply to losses don't actually come into play here?

Kitces: Right. And it's much easier here. So, if we're going to switch from an old investment position that we didn't like to something else, we don't have to worry about wash sales or anything at all because we're changing.

The next opportunity that we have, though, is: we can actually say, I kind of like the investment that I'm in, but I might sell at some point in the next couple of years, which means they've got this looming capital gain at potentially higher rates. So, why don't I recognize the gain this year, which essentially means I'm going to sell it and buy it back. I don't even intend to change my economic position; I just want to recognize the gain.

Now, there we sort of have that risk of wash sales--except we actually don’t with gains. The wash sales are written specifically for losses, because losses essentially are a tax deduction, and Congress said we don't want you take the tax deduction if you still own a substantially identical security.

They made no rule like that for gains. There is no rule that says, thank you for selling something recognizing a gain, you owe us taxes, but please keep your tax dollars, since you bought it back. No rule like that. Congress is happy to take your money, except it happens to be very good tax planning.

So, we see some people going so far as to saying, look, if I was going to sell this at any point in the next few years and recognize a gain, I'd rather pay at the lower rates than the higher rates. I don't think it's going to appreciate so much from here to overcome a significant increase in capital gains rates. I'm just going to sell it now, I'll report the capital gain, I'll buy the position right back--in fact if it's a stock or an ETF something that's traded intraday, I could buy it back within seconds or minutes. If it's a mutual fund, I’d probably have to sell it today and buy it back tomorrow. But I can essentially buy it back almost immediately, retain my ongoing investment, just recognize the capital gain and get it in at today's rates.

For people who are in the upper brackets, the appeal is I get 15% instead of 20%. For people in the lower brackets, it’s actually kind of easier--you're selling and you're getting a 0% capital gain rates. So it's like you step up a basis for free, you don’t have to pass away, which is the only other way you get a step up in basis. You just sell and buy it back in the lower brackets, and your basis steps up.

Benz: So, the risk is, though, Michael, that if someone in the higher bracket, who will in fact owe taxes on this gain, goes ahead and does this. What if tax rates stay the same, and you've realized this gain and you have to pay taxes on it, but you didn't really need to?

Kitces: That essentially is the risk of the strategy. If we sell and end up buying it back, we recognize a gain, and then rates don’t actually go up, we just paid 15% in taxes this year instead of 15% taxes in the next year or a year or two or three [down the road] whenever you are going to sell it. In essence, what we've lost is the time value of money. So, whatever those tax dollars are going to be and whatever those tax dollars were going to appreciate at.

Now, classically in a lower-return environment, when the returns of everything are kind of diminished, so too is the time value of money. So, generically, as we would economically evaluate this, the potential damage is less simply because, where returns are low, you were only going to do so much with those tax dollars anyways.

But beyond that, as we look at it overall, for really high-income folks, even if we ultimately extend the current rates, we still have a 3.8% tax that's going to layer on top, from a completely separate set of rules.

So, we see a lot of folks at the very high income levels doing this, because even just going basically from 15% to 18.8%--with the 3.8% surtax--is still painful enough that it makes sense to have harvested something this year, if you were going to sell it for next year. Maybe not something we harvest this year that we weren’t going to sell until 2020--we might roll our dice and see where we're going to end out there. But for people who were going to sell in the next few years anyways, even the 3.8% tax increase on a relative basis--3.8% on a 15% base--is a very significant tax increase. That's upwards of 20%.

Benz: The last thing I want to cover with you is that, I have been hearing from some of our users that they are concerned about people executing this strategy all at once, will that put downward pressure on stocks at some point between now and the end of the year. What's your take on that question?

Kitces: Good question. I’ve heard this a little bit as well. I don't see any real risk to it, and really there's two reasons. One, ultimately the amount of selling we're talking about both for individuals and just the individuals who want to harvest and just the positions that are up and just in the individual investor marketplace--because institutions don't really get much benefit to this--it's just not a large enough dollar amount.

And in theory most people are really only doing one of two things: They are selling an investment that they were going to sell anyways and buying something else, which means, I guess, you might move the stock price of the thing you sold and the thing that you bought a little, but that's how markets normally function. We sell the things that we don't think are going to do well; we buy the things that we think are going to do well, and the price is adjusted accordingly. Taxes are just essentially a frictional point to that, and we're taking out a little bit of the friction.

But for people who are just going to do the pure version of the harvesting, so I sell it and I buy it back, there's no net selling--we're still remaining in the market. So, I don't really see much likelihood that these kinds of transactions would have any reason to cause any material amount of net selling and drag markets down.

Benz: Well, thank you, Michael. It sounds like it's very individual-specific but also could be a very interesting strategy between now and year-end. Thanks for joining us.

Kitces: My pleasure.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.