Paying Capital Gains Taxes Now May Be Wise

by Chuck Jaffe

These are strange times for investors.

Consider the standard advice to avoid paying capital gains taxes to Uncle Sam for as long as possible. But in a sign of just how awkward things are, some investors are accelerating their tax bills, paying the government now to avoid the higher taxes they expect down the road.

Let’s look at the reasons why: Tax cuts enacted during the George W. Bush Administration are due to expire at the end of 2012. The current 15% tariff on capital gains could rise to 20% in 2013, barring an extension from Congress. Depending on who controls the White House and Congress after the election in November, rates could go even higher.

One thing most observers do not expect at this point is a capital-gains tax cut. Accordingly, some investors have decided to pay taxes on stock gains at the current rate, rather than the future one.

So shareholders are selling long-time holdings - recognizing the gains - and then buying the stock right back. Many investors know of the “wash-sale rule,” where an investment sold to harvest a tax loss can’t be repurchased for 30 days, or the loss is washed off the books. But that applies only when losses are being harvested, not gains, so the quick turnaround triggers the taxable event and the investor can still have the stock back.

Not right for everyone

“It’s definitely not right for everyone, but there are some situations where people have made a lot of money in a stock that they want to hold onto for a long time, and they can lock in what is likely to be the lowest gains rate they’re going to see right now, or between now and the end of the year,” said Peter Lang, managing director at HighTower Advisors’ office in Harrison, N.Y. “If you have long-term holdings in taxable accounts, you could see some meaningful savings depending on what happens to tax rates.”

That turns conventional tax planning on its ear, but it’s no reason for a shareholder to sell. In fact, even people who suggest paying capital gains now admit that only a small group of investors will find an advantage.

Indeed, for some people accelerating gains is a bad idea, no matter the tax rate.

Older investors with long-time holdings who effectively have been letting death sort out their taxes (leaving the stock to heirs at a stepped-up cost basis) are not going to want to sell and repurchase now. They would lose the tax benefits they’ve been waiting for.

Likewise, any investor whose shares are close to their target price would be foolish to sell and re-buy the stock. If the security hits their target price and is sold within a year after the tax harvest, that last bit of gains would be considered short-term, and taxed at the higher ordinary-income rate.

Also, anyone with a strong sell discipline should not junk their methodology and make moves based on taxes.

“Once you let something take over and change your discipline, you have no discipline,” said Brent Wilsey of Wilsey Asset Management in San Diego.

Tax sense

But if you are the classic buy-and-hold baby boomer who, say, bought Apple Inc. 10 years ago and who has seen an annualized average gain of more than 50% ever since, speeding up the tax clock might make sense.

If you put $1,000 into Apple a decade ago, it’s worth roughly $56,000 today.

If you sell now - locking in a gain of $55,000 - it is going to create a tax bill of $8,250 at today’s 15% capital-gains tax rate.

If you wait and the capital gains rate becomes 20%, the tax bill on that same gain would be $11,000, a difference of $2,750.

An investor who accelerates gains is locking in a return equal to the percentage increase in taxes, or 5% of $55,000.

There are “opportunity costs” — the loss of investing power from the money they use to pay Uncle Sam - but at a time when Treasury rates are so low, locking in at least 5% on gains is highly attractive. Effectively, it’s an investment wager against Washington’s ability to hold the line on capital gains taxes.

At the least, this is something for investors to consider as they rebalance a portfolio. This might be the year to unload some longtime gainers because making the same move next year could be more costly.

There’s no rush; just run the math to see what makes sense as the election unfolds and the tax deadline is addressed. If the 15% capital gains rate isn’t extended, there’s a value to accelerating gains; the bigger the tax hike, the more attractive the move.

“Most of the time, people are looking at ‘How do I mitigate my taxes in a given year?’” Lang said. “This year. it’s ‘How can I increase my taxes, because I may never get a better deal on my gains than I’ve got right now.’”

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