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August 13, 2012
Long-term capital gain harvesting in 2012 can produce extraordinary investment returns for many taxpayers. Because the returns are highly sensitive to changes in the time horizon, tax rate differential, growth rate of the stock to be harvested, and the taxpayer’s opportunity cost of capital, a thorough quantitative analysis is necessary before proceeding with the strategy. This discussion includes a model for performing this analysis and draws general conclusions about when 2012 gain harvesting makes sense.
As you probably know, the Bush tax cuts are scheduled to expire at the end of 2012. Assuming that Congress does nothing in the meantime, tax rates on long-term capital gains will increase substantially in 2013 (see attached chart).
For high-income taxpayers, most capital gains will also be subject to a 3.8% Medicare surtax in 2013, raising the rate for high-income taxpayers to 23.8%. Thus, the capital gains rate for taxpayers in the lowest ordinary income tax bracket would increase by 10 percentage points (0% to 10%); the rate for middle income taxpayers would increase by 5 percentage points (15% to 20%); and the rate for high-income taxpayers would increase by 8.8 percentage points (15% to 23.8%).
This suggests that taxpayers should harvest all long-term capital gains (LTCGs) on publicly traded stock in 2012 before rates go up. The taxpayer would immediately reinvest the sale proceeds in the same stock and sell it whenever he would have sold the original shares. Thus, from an economic perspective, the only change is that the stock is sold, and gain is triggered in 2012. Under the wash-sale rules of Internal Revenue Code Sec. 1091, losses on the sale of stock or securities are denied if the taxpayer acquired substantially identical stock or securities during the period beginning 30 days before the sale and ending 30 days after the sale. Because there is no comparable provision for gain recognition, a seller who harvests gains can repurchase immediately, eliminating the risk that the value of the stock or security will increase significantly while he or she is out of the market.
However, deciding whether to use the strategy is not as simple as it might first appear, for two reasons. First, the lower rates must be weighed against the loss of tax deferral. The taxpayer is paying tax at a lower rate but paying it sooner. In addition, the economic substance doctrine might apply, delaying the repurchase or requiring the taxpayer to buy different stock.
Reduced tax rate versus loss of deferral
The 2012 gain harvesting strategy could be thought of as paying tax in 2012 to buy tax savings in a later year. By analyzing it in this way, we can calculate a rate of return on the 2012 investment over time and treat gain harvesting as an investment decision.
Whether a taxpayer should invest in the gain harvesting strategy would then depend on whether his or her return exceeded his or her opportunity cost of capital (the return he or she could have earned on another investment of comparable risk). If so, gain harvesting would be a favorable investment. The following simple example illustrates the basic model for making this decision:
In 2012, Marge owns XYZ stock with a basis of $200 and fair market value of $1,200, which she planned to keep until 2013. Assume that the stock grows in value by 5% per year. Marge’s LTCG rate in 2012 is 15%, and Marge’s LTCG rate in 2013 is 20%. The following charts compare the tax consequences of (1) forgoing gain harvesting in 2012 and selling the stock in 2013, and (2) harvesting the gain in 2012, immediately repurchasing the stock, and reselling in 2013.
Marge ends up with $44 more in the gain harvesting alternative ($1,092 - $1,048). This makes the rate of return 29.33% (44/150). Because this is presumably far above Marge’s opportunity cost of capital, she should harvest her gains. To explain the concepts in the simplest manner possible, the analysis uses small numbers and ignores transaction costs. If the return on investment (ROI) for the gain harvesting strategy is close to the taxpayer’s hurdle rate for deciding whether to invest, transaction costs should be factored into the analysis. In the present example, the ROI is so great that transaction costs would make little difference.
Independent variables—sensitivity analysis
The decision about whether to harvest gains is very fact sensitive. Sometimes, it will be very favorable, as in the previous example, but often it will not. The key independent variables are:
Note that the taxpayer’s basis in the stock has no effect on the return on investment (ROI) because there is a proportionate decrease in the amount invested and the ROI.
The shorter the time period between the gain harvesting sale and the second sale, the more favorable gain harvesting will be. To illustrate this point, we will assume the same facts as in the preceding basic example except for extending the time period between sales. As the chart shows, the desirability of gain harvesting declines quickly as the time horizon increases. If the taxpayer harvests gains in 2012, repurchases the stock, and sells in 2013, the taxpayer must be sure to wait for at least a year and a day to obtain a long-term holding period on the subsequent appreciation. The worst possible candidate for gain harvesting would be an older taxpayer in poor health with a low basis, who plans to die with the stock to create a stepped-up basis for his or her heirs. For such a taxpayer, the ROI would be zero because no tax would ever be paid on the pre-death gain. Note that negative returns are possible.
The numbers indicate that the 2012 gain harvesting will be extremely effective if the taxpayer planned to sell the stock within the next few years but will prove to be a poor investment if the taxpayer planned to hold the stock for a long period of time. Thus, it will be far more favorable for a taxpayer with an actively managed portfolio, than for one using a buy-and-hold strategy.
Robert S. Keebler, CPA, MST, AEP (Distinguished), is a partner with Keebler & Associates LLP. He is the author or co-author of many books and treatises on wealth transfer and taxation. Peter J. Melcher, J.D., LL.M., MBA, is a partner with Keebler & Associates, LLP, specializing in tax planning for high-net-worth individuals. He is a frequent author for national tax journals. Stephen J. Bigge, CPA, CSEP, is a partner with Keebler & Associates, LLP. He specializes in estate, gift and retirement planning, charitable gift planning, as well as trust and estate administration. Christopher W. Schuler, MBA, is a consultant with Keebler & Associates, LLP, whose emphasis is in developing comprehensive financial, estate, and income tax analyses.