Year End Tax Planning for Capital Gains and Losses

FROM FORBES.COM

We are at the time of year when many investors are considering year-end tax planning for capital gains and losses.  With the election of Donald Trump and Republican majorities in both houses of Congress, the likelihood of tax law changes in 2017 has significantly increased. If any of these proposals are enacted, this will most likely result in lower capital gains taxes in 2017. Thus, the general rule would be to recognize your capital losses this year and postpone your capital gains until 2017. However, there are some exceptions to this general rule.

Tax Proposals

There have been a number of Republican Congressmen who have made tax proposals over the last several years. The two that seem to have the most traction are the ones introduced in 2014 by former House Ways and Means Committee Chairman David Camp and the Tax Reform Blueprint issued in 2016 by Speaker of the House, Paul Ryan. Both proposals would revert to the old scheme of a tax deduction for a portion of the long-term capital gains, rather than a specified rate for long-term capital gains. Both proposals envision three rates for ordinary income which would apply to short-term capital gains. The Ryan plan would have 33%, 25% and 12% brackets, with the highest bracket applying to income over $231,450 for joint returns. The long-term capital gain deduction would be 50%, making 16.5% the highest effective rate on long-term capital gains. With the deduction for long-term capital gains, the Camp plan would have a 21% highest effective rate.

A deduction for a portion of the long-term capital gains may benefit taxpayers more than an equivalent lower fixed rate on long-term capital gains since it reduces Adjusted Gross Income (AGI) and Taxable Income (TI). This would potentially reduce state income taxes unless states whose income is based on AGI or TI amended their laws to ignore the new capital gains deduction. While the long-term capital gains deduction works out better for higher income taxpayers, it would result in a tax increase for the lowest bracket taxpayers from 0% to 6%, and a slight increase for some middle bracket taxpayers from 15% to 16.5%.

President-Elect Trump’s tax proposal has the same three tax brackets applying at similar levels of ordinary income. He would keep the current law on long-term capital gains (explained below).

All three proposals would eliminate the Alternative Minimum Tax (AMT) and eliminate the 3.8% Affordable Care Act tax on Net Investment Income. Thus the highest long-term capital gains rate under any of the proposals (20%), is lower than the 23.8% current rate.

Even with a Republican President, House, and Senate, there is no guarantee that a tax bill will be enacted next year or at all. There is, however, a reasonable chance that tax rates will go down next year and virtually no chance that they will go up.

FAQs

Q. Should I recognize all of the unrealized capital losses I have now, before the end of 2016? 

A. Absent unusual circumstances, you should recognize capital losses to the extent of your capital gains, plus $3,000.  Why not more?  Any losses in excess of this amount will result in no current income tax benefit.

Q. I have unrealized capital losses far in excess of my capital gains. Why shouldn’t I recognize all the losses I can? 

A. There is hardly any tax advantage (or disadvantage) to creating a capital loss carryforward, as will be discussed more fully below.  However, if you recognize capital losses, there are likely to be undesirable nontax consequences:

First, there may be trading costs, both commissions and/or bid/ask spreads.

Second, in order to recognize the losses, you must not acquire the same or a substantially identical security within 31 days before or after your sale.  The sale of part or all of your stock portfolio changes your asset allocation.   You could buy similar, but not identical securities and sell them after thirty days.  However, you may not do as well with your “second choice” investments as with your first choice.

Third, there could be a time lapse between selling one portfolio and acquiring another.  While the time lapse could work in your favor, it is one more variable to consider before taking losses that provide no current tax benefit.

Finally, in the event that your new investments skyrocket in value (in excess of your capital losses), you will have to wait a year to sell or be stuck with higher-taxed short-term capital gains next year. (You should be so lucky!).

If your unrealized capital losses are in no-load mutual funds, the first and third points above would not apply (unless you are subject to a redemption fee).

Q. If I don’t realize the unrealized losses now, they will go away in the future as the investments increase in value. Why should I give up the opportunity to use these losses in the future? 

A. As to any particular investment, you are not giving up the loss by not realizing it currently.  When you recognize capital losses and repurchase securities in 31 days, you now have a lower tax basis in your investment. This will cause a larger gain when the investment is sold, offset by the capital loss previously recognized.  If instead of selling this year and recognizing the capital loss, you retain the investment; then you will retain the high tax basis of the original investment to use at the time of sale.  In either case, you will recognize the same net gain or loss upon ultimate sale.  The only difference in the total gain or loss between holding the investment and selling it this year is any change in the value of the asset that occurs between this year’s sale and the subsequent repurchase.

Q. Why not stockpile capital losses to use against future capital gains? 

A. There is generally not much benefit to stockpiling losses now.  If you have a high portfolio turnover, you will likely recognize the losses or have smaller gains by selling the securities in the normal course.  For example, if your entire portfolio turns over before the end of 2017, stockpiling losses will have the same tax result as is otherwise achieved by not selling this year.

In a low turnover portfolio, it may be several years before capital gains are generated.  In this case, it may be possible to find other losses in the future to deal with whatever gains may occur.

But there’s always an exception:  In some situations, stockpiling might be a useful strategy.  Take for example a situation in where all three of the following expectations exist:

1. There is a likelihood that a substantial capital gain will be recognized in 2017;
2. The current losses in securities will be eroded in 2017 due to price increases; and
3. The proceeds from the sale of the loss securities that are sold in 2016 are used to repurchase securities that are not sold at gains in 2017.

If all of these factors exist, the “sell now” strategy would result in the acceleration of the use of the capital losses.  However, unless all of these factors exist, there is unlikely to be much benefit from stockpiling capital losses.

Q. I have long-term capital gains this year that will be taxed at 20%, but my only losses are short-term capital losses, which could offset short-term capital gains next year that would be taxed at 39.6%.  Should I recognize the short-term losses this year? 

A. This is another question that is heavily dependent on individual circumstances.  If you expect to have short-term capital gains next year and do not expect to have enough short-term capital losses and net long-term capital losses available to offset those gains, you should defer taking the short-term losses this year.  Hedge funds, for example, have historically generated large amounts of short-term capital gains.  You may wish to postpone capital losses to January 2017 to the extent that:

• you expect your hedge funds will have short-term capital gains in 2017; and
• you do not expect to have sufficient losses in 2017 to offset the expected short-term capital gains.

In most other circumstances it should still be beneficial to offset short-term losses against long-term gains.  Remember that unrealized short-term gains and losses will become long-term after the one year holding period is achieved.  So you can often avoid ending up with net short-term capital gains.

Q. What are some of the other situations in which it may not be desirable to recognize capital losses to offset long-term capital gains? 

A. Taxpayers who are in the 15% tax bracket pay no federal income tax on their capital gains to the extent that their taxable income does not exceed $75,300 on a joint return, $37,650 on a single return or $50,400 filing as a head of household in 2016.  There may be state income tax due on the capital gain.  Taxpayers in the 15% bracket who pay no income tax on their recognized long-term capital gains would be well advised to hold off recognizing losses in 2016 since the capital losses would be offsetting nontaxable income (except to the extent of state tax benefit or the $3,000 which can be applied against ordinary income). Furthermore, taxpayers in this situation would be well-advised to recognize additional long-term capital gains to use up their allowance of tax-free capital gains.

Some taxpayers have long-term capital gains that exceed their taxable income due to ordinary losses or itemized deductions. Careful analysis will be required to maximize the benefit of capital losses.  Generally, it will not be desirable to offset the full taxable income.  Consideration of the alternative minimum tax implications will play an important part in the loss recognition planning in this situation.

 Current Tax Rates

The tax rate on long-term capital gains depends on the taxpayer’s taxable income. Married couples filing a joint return pay a 20% tax rate on long-term capital gains to the extent that their taxable incomes exceed $466,950 in 2016. The threshold for the 20% bracket for Single and Head of Household status is $415,050 and $441,200. There are two additional taxes on joint return filers with income over $250,000 and single and head of household filers over $200,000: the net investment income tax and the “Pease” tax. Taxpayers with modified adjusted gross income (“MAGI”, which is higher than taxable income) over $250,000 (Joint) or $200,000 (Single or Head of Household) are subject to the 3.8% tax on net investment income. The “Pease” tax is a 3% disallowance of itemized deductions for joint return filers whose MAGI exceeds $311,300; $285,350 for head of household filers and $259,400 for single filers. This generally increases the marginal tax rate by 1.2%. Thus the maximum long-term capital gains rate is 25% for most taxpayers (23.8% for taxpayers not affected by the “Pease” tax). For short-term capital gains, the Federal income tax rates top out at 44.6% (39.6% + 3.8% + 1.2%). State income tax would further increase these rates.

Married taxpayers filing a joint return pay a 15% tax on long-term capital gains to the extent that their income is between $75,300 and $466,950. For single tax filers the 15% rate applies to income between $37,650 and $415,050 (head of household filers, $50,400 and $441,000). To the extent of taxable income below this level, there is no Federal income tax on long-term capital gains.

 Rules For Applying Capital Gains And Losses

• Short-term capital losses must first be used to offset short-term capital gains.
• If there are net short-term losses, they can be used as an offset against the net long-term capital gains.
• Long-term capital losses are similarly first applied against long-term capital gains, with any excess applied against short-term capital gains.
• Long-term capital gains are taxed at rates of 25% (real estate recapture) or 28% (collectibles) instead of the usual rate.
• Net long-term capital losses in any rate category are first applied against the highest tax rate long-term capital gains.
• Capital losses in excess of capital gains can be used to offset up to $3,000 of ordinary income.
• Any remaining unused capital losses can be carried forward and used in the same manner as described above.
• Unused capital losses expire in the year of the taxpayer’s death, to the extent they remain unused on the final income tax return. On a joint tax return, each spouse’s capital losses must be tracked separately for purposes of this rule.
• The capital losses of the decedent spouse may be used to offset capital gains of the surviving spouse in the year of death, including those gains incurred by surviving spouse after the decedent’s death.