Now that the election is over, it appears more likely that the Bush-era tax cuts will expire, at least for upper-income taxpayers. In addition, implementation of the Patient Protection and Affordable Care Act, commonly known as Obamacare, will usher in an additional Medicare surtax of 3.8 percent on unearned income above certain threshold levels. Individuals holding appreciated assets may be wondering if they should recognize capital gains at 2012 tax rates. A number of factors should be considered before deciding whether or not to recognize capital gains in 2012. Several of these factors are briefly discussed later below. As always, you should consult with us to discuss the impact of a capital gain strategy on your overall portfolio and your individual income tax liability.
Future Tax Rates
It is expected that starting in 2013, the top federal capital gains tax rate will be 23.8 percent, consisting of the following: The top capital gains tax rate of 20 percent (up from 15 percent in 2012) plus an additional Medicare surtax of 3.8 percent. This is applied to the lower of net investment income (e.g., capital gain or dividends) or Modified Adjusted Gross Income (MAGI) over $200,000 ($250,000 if married).
Even at this late date, 2013 tax rates are not assured, and Congress may very well enact legislation that changes 2013 tax rates altogether. As unreliable as predicting 2013 tax rates may be, prediction of long-term future tax rates is even less reliable. Therefore, the possibility that tax rates will differ from the expected 2013 rates should be considered.
Investment Returns and Expected Holding Period
The time value of money makes it preferable to delay payment of income taxes until a later period. However, since future income tax rates are expected to be higher, recognition of capital gains in 2012 may prove to be beneficial. Factors that influence the advantage/disadvantage of recognition of capital gains in 2012 include the future investment return, the expected number of years before the asset is sold (holding period), and future tax rates. As mentioned earlier, assuming a current capital gains tax of 15 percent and a future capital gains tax of 23.8 percent for a given expected return, recognition of capital gains in 2012 should be considered if the asset would otherwise be held for less than the number of years indicated in the table below.
Note as the expected return of the asset increases, the number of years that an asset needs to be held to justify deferral of capital gains decreases. When determining the required holding period, inflation-adjusted (real) returns should be used, since inflation has a corrosive effect on purchasing power over time. If an asset is expected to be held indefinitely (until the taxpayer’s death), or if the asset is expected to be gifted to charity, capital gains taxes will likely not be incurred for this asset in the future. Thus, recognition of capital gains should not be considered. Conversely, if the taxpayer has high liquidity needs that would shorten the assets expected holding period, recognition of gains in 2012 could prove to be advantageous.
If capital gains are expected to be realized before the holding period indicated above, either through turnover, portfolio rebalancing or diversification, consideration should be given to recognizing capital gains at 2012 rates. Reduction of large, concentrated positions should be strongly considered, as diversification provides additional benefits through reduction of overall risk within a portfolio.
State and Local Tax Implications
The above discussion focuses on federal income tax only. While this may be appropriate for jurisdictions that have little or no income tax burden, most states and many local jurisdictions impose an income tax, primarily based on federal taxable income. Taxpayers living in a high tax jurisdiction, such as California or New York, should be mindful of the impact of capital gains on state and local income tax liabilities.
