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.