The daily fiscal cliff news coverage is causing irrational investor behavior regarding unrealized long-term capital gains (LTCG). Without congressional action the LTCG rate is set to increase from 15% in 2012 to 20% in 2013. In addition, high earners are subject to a 3.8% Medicare surtax applied to all capital gains. (income greater than $250,000 for married filing jointly, $200,000 for singles, $125,000 for married filing separately). The proposed tax rate changes are far from certain and may not be resolved well into 2013.
In order to accurately determine if a year-end sale is the right decision, the pros and cons must be weighed against each other.
Reasons to sell appreciated assets by year end
- When the money is needed – If the money is needed this year or in the near future, take advantage of the guaranteed 15% LTCG rate.
- Rebalancing needs – Selling an asset as part of a routine rebalancing process is another good reason to sell an asset by year end.
What are you giving up?
- Charitable donation step-up basis – If charitable giving plans are in the near future, realizing the gains now would result in unneeded taxes paid.
- Estate step-up basis – Under current law, all appreciated assets get a step-up in basis upon death. While this will not help the owner of the stock, the estate, spouses and heirs could greatly benefit by this rule.
- Built Up Long-Term Losses – Long term losses will become 33% more valuable if the capital gains rate goes up to 20% (59% more valuable if the 3.8% Medicare surcharge is applicable to you).
- Smaller Tax Bill – Selling assets with long-term capital gains will increase the 2012 tax bill. Another item that is often not considered is the Alternate Minimum Tax (AMT). A large long-term capital gains sale could easily trigger AMT on an individual’s tax return negating the small benefit of selling the gains prior to a rate increase.
Payback Period
The year end tax planning decision is purely a factor of when the assets will be needed. An example is the best way to look at the situation. If an investor has a $100,000 LTCG and sells them in 2012, that investor will have a federal income tax bill of $15,000, excluding AMT implications. If that investor were to buy back the stock, they could only use the remaining $85,000. Over time the $5,000 tax savings (between a 15% and 20% LTCG rate) would be offset by the compounding interest realized by the $100,000 investment over the $85,000 investment. With average real market returns of 6%, the payback of holding LTCG is less than 6 years.
The table below depicts the required number of YEARS that LTCG must be held to come out ahead of the potential tax changes in 2013:
New LTCG Tax Rate
|
Real Growth Rate (Excluding Dividends)
|
|
2%
|
4%
|
6%
|
8%
|
10%
|
20%
|
17.5 yrs
|
8.9 yrs
|
5.9 yrs
|
4.4 yrs
|
3.5 yrs
|
23.8% (20% + 3.8%)*
|
27.4 yrs
|
14.5 yrs
|
9.8 yrs
|
7.3 yrs
|
5.8 yrs
|
*This rate applies to high income earners
The long term capital tax rates remain uncertain. Making portfolio decisions based upon a potential tax law change is a mistake for both clients and advisors. While each situation is unique, there is no compelling reason that realizing capital gains now is a better decision than doing nothing.