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Rekenthaler Report

The Senate's Proposed Investment-Tax Hike Is a Flop

The provision is strange on the surface, and stranger yet underneath.


Upside Down
Who ever thought that a bill that increases investment taxes would have been sponsored by Republicans?

Such is currently the case. In the Senate, Republicans introduced a provision to the Tax Cuts and Jobs Act, previously passed by the House of Representatives, that would boost taxes on realized investment gains. The proposed raise is implicit, in that it affects how those gains are measured rather than the rate that is applied to them, but a tax hike is a tax hike. This would be a tax hike.

The Proposal: Part One
There are two types of realized investment gains for mutual funds: a) those that occur within a fund, and thus are controlled by the portfolio manager; and b) those that occur outside a fund, and thus are controlled by the shareholder.

The first type of realized gain is defined by the Investment Act of 1940. There is no reason save for taxes to differentiate between a fund's realized investment gains, achieved when it sells a security, and its unrealized gains, achieved by holding that security. In either case, the net asset value rises by the same amount. However, per the Investment Act, funds are required to distribute substantially all their net realized gains each year, in the form of a capital gains distribution.

Naturally, funds wish to minimize those distributions; there is no advantage whatsoever in paying out more rather than less, and a clear disadvantage for those shareholders who hold their funds in taxable accounts. The method that funds use to reduce the size of their distributions is the same as used by retail investors for their accounts: designating specific lots for their security sales.

The initial version of the Senate bill removed that tax-management tool. It mandated that funds use the first in, first out (FIFO) approach for determining their securities' cost basis. Portfolio managers no longer would be able to select which lots they sold; the calculation would instead follow a mechanical, unchanging rule.

Fund companies howled. The Senate retreated. The current version of its bill no longer requires that portfolio managers use FIFO. They may continue to identify specific lots, as they have customarily done. Directly, a victory for the mutual fund industry. Indirectly, a victory for investors.

The Proposal: Part Two
Don't celebrate too vigorously. The Senate left intact the second portion of the provision, the part that governs how investors determine their gains (or losses), when they sell a fund. No longer will fund owners be permitted to designate their highest-cost lots for sale to lower that year's tax bill. For computing cost basis, they will be required to use either FIFO or the security's average cost (if their broker and/or fund company provides that figure).

The same rule applies to securities other than funds. Stocks, bonds, and other financial assets are treated similarly. The security's cost basis must be calculated by FIFO or average; no further discretion is permitted. (The rule, if passed, would take effect when the bill is ratified. It would not be grandfathered. For that, at least, investors can be thankful.)

These Are Republicans?
Curiouser and curiouser. No surprise that Senate Republicans surrendered to the fund industry. When the donor class speaks, Senators from both major parties listen. Such is the way of Washington. However, it is distinctly peculiar to see the Republicans target the investor class. This provision hits what historically has been their demographic--those wealthy (and old) enough to own taxable investments, but not so wealthy as to benefit from carried-interest rules.

To be sure, the bill's overall effects are complex; if the Senate's version passes in its current form, many investors will pay lower overall taxes, even as they report higher capital gains. (Alas, I do not appear to be among that fortunate crowd.) Nonetheless, the item puzzles. It is odd to see Republicans write legislation that they would denounce, had they not themselves offered it.

If the Republicans won't criticize the provision, because they authored it, and the Democrats won't, because they favor it (which they mostly do), then that doesn't make for many opponents. Permit me to volunteer. Regardless of what one thinks about the general principles of this clause--that is, if Wall Street deserves to be more heavily taxed, and the extent to which the GOP should raise revenues in a bill that is, after all, entitled "Tax Cuts" (and which has been described by the president as "Tax Cuts Cuts Cuts")--its specifics are silly.

Unintended Consequences
They are silly because the provision promotes wasteful investor behavior.

Brokerage firms, obviously, do not share client data. Morgan Stanley doesn't send monthly updates to Schwab of its customer records. Thus, the bill's accounting rules only apply to securities that are possessed within a given brokerage firm. If all your  Apple  (AAPL) stock is at Fidelity, then when you sell Apple shares you will be informed of your cost basis. No choice. However, if some of your shares are at Fidelity and some at Vanguard, then you can select which shares you wish to sell. You have just skirted the rule--by having multiple brokerage accounts.

Well, that's stupid. Who wants to go through the hassle of having more investment accounts, rather than fewer? However, such is the incentive created by the proposed legislation. For tax purposes, investors would be best served by putting some of their taxable investments here, some there. For every other purpose, they would be ill served by refusing to consolidate. Putting the investor in a no-win situation qualifies as a bad unintended consequence.

There's no way for lawmakers to fix the problem. They can't reasonably insist that investors who hold a security at several brokerage firms sell their oldest lots, because effectively that would legislate which brokerage firm people use for their trades. Also, even that requirement wouldn't work for mutual funds. Want the flexibility to choose which cost-basis portion of your S&P 500 index fund to sell? Buy a different index fund each time that you invest; then you can select your lot at will.

This provision fails. Perhaps House Republicans will see what the Senators missed and delete this section from the final bill, should the legislation reach that stage. One can hope.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.