House Democrats recently presented a preliminary tax proposal that is intended to help fund President Biden’s proposed $3.5 trillion dollar infrastructure package.  The current proposal targets high earners and corporations through increases in income taxes, corporate and business taxes, as well as estate taxes.  One update within the proposal that may give wealthy investors particular concern is an increase in the capital gains rate.  While the proposed increase is not as severe as originally feared, the top capital gains tax would see an increase from 20% to 25%.  Currently, the capital gains rate is 20% for single taxpayers with income over $441,451 and for taxpayers who are married filing jointly with income over $496,601.  Additionally, the change to 25% could be effective as of the date the proposal was presented, September 13, 2021.  Any gains that were recognized prior to the proposal date would still be subject to the 20% rate.

This paper will examine the impact of a capital gains tax increase on an investment portfolio, how the increased capital gains rate may actually result in decreased tax revenue, and finally introduce a tax efficient investment management strategy that investors should consider.

Tax Drag on Investments

It is important to take into consideration the impact of taxes when making investment decisions. Tax drag is defined as the loss in return on an investment due to taxation.  This is an important concept because taxes can eat into an investor’s returns, leaving less money to compound over time.  Ultimately, it is not what you earn, but what you keep that matters. Let us look at an example.

In figure 1, as shown below, we assume an investor purchases $1,000,000 of an S&P 500 Index fund, growing at an annualized rate of 11.55% and a long-term capital gains rate of 20%.  If that investor were to purchase the fund on December 31st and sell on December 31st the following year, pay the taxes (assuming the top long-term capital gains rate of 20%), and immediately reinvest the proceeds and continue to sell and reinvest each year for the next ten years, that investor would be left with a balance of $2,420,008.63 at the end of the ten-year time-period.  On the other hand, if that same investor were to purchase $1,000,000 of an S&P 500 Index fund and let the balance compound annually over the same ten-year time-period without realizing the gains and paying taxes each year, only paying taxes at the end of ten years, the balance would be $2,586,633.50.  In this example, the tax drag from paying the taxes each year versus letting the balance compound, equates to a decreased investment gain of $166,625 or a return of 16.7% lower over the same ten-year time period.  The effects of tax drag versus compounding growth are critical when examining how wealthy investors may react to an increase in capital gains rates.

Figure. 1 (assumes annualized growth of 11.55% and a 20% capital gains rate)

Impact of Tax Drag

Source: Bloomberg

Could an increase in the capital gains tax be a tax revenue detractor? 

If we were to examine the same example but apply a 25% capital gains tax rate, as shown in figure 2 below, we can see that the tax drag over the same ten-year time period diminishes the investment return by $192,393.68 or 19.2%.

Figure. 2 (assumes annualized growth of 11.55% and a 25% capital gains rate)

tax drag

Source: Bloomberg

This example does not include state income taxes or the Medicare surtax of 3.8%, which is a tax on investment income for individuals with a combined net investment income and modified adjusted gross income of more than $200,000 for single filers and more than $250,000 for married filing jointly.  If an individual were to live in a high tax state such as New York or New Jersey, taxes on investment income could be nearly 40%!  How might investors react to these increased tax rates?

Investors typically sell investment assets for one of two reasons.  First, they may need to sell assets to generate cash for liquidity needs.  For example, an individual may need to sell down assets if they are looking to purchase a new home or to simply support general living expenses.  Second, investors may look to reposition their investable assets to take advantage of changes in the economic landscape (i.e., rotating from Large Cap to Small Cap or U.S. to International) or may be adjusting their overall risk profile as they adapt to changes in life events.  In either case, a higher taxation on realized gains creates a “lock in” effect.  Investors will find that they are financially rewarded by deferring the sale of assets for as long as possible.  As a result, investors are likely to seek out alternatives to selling their assets to achieve liquidity or diversification goals.

For investors looking to sell assets and raise cash, who may have a need to coordinate different timing for tax planning, one alternative they may consider is using margin or security backed loans, rather than selling their investments.  A margin or security backed loan allows you to borrow against the value of the investments in your portfolio, while using the assets in the portfolio as collateral for the loan.  For example, an investor who is looking to raise $500,000 for cash needs and has a $5,000,000 portfolio with a cost basis of $1,000,000, could face a tax liability of approximately $100,000 if the capital gains rate were to increase to 25% (excluding Medicare surcharge and state taxes).  Rather than selling assets, let us assume that same investor borrows the $500,000, while letting the original $5,000,000 continuing to grow.  Over a five-year time-period, the investor could net approximately $100,000 in additional return, even after paying back the loan.[1]  In addition to yielding nearly $100,000 in investment return, the investor now has additional time to weigh their decisions around realizing taxable gains.

While borrowing is one alternative to deferring gains, portfolio hedging strategies can also be an effective strategy for investors who are looking to adjust the risk profile of their portfolio, while continuing to defer gains.  Portfolio hedging strategies typically involve the use of financial derivatives, such as options, to minimize the negative impact of an investment.  Option contracts give the buyer the right, but not that obligation to buy or sell an underlying asset at an agreed upon price and date.  There are two types of option contracts, “calls” and “puts.”  Call options allow the holder to buy an asset at a specified price, while put options allow the holder to sell at a specified price.  For example, if an investor owns a large position in Apple stock and is concerned about short-term price swings and wants to protect the portfolio from losses, they could consider purchasing “put” options on Apple.  Because put options appreciate when the underlying asset falls, a decline in the price of Apple would be offset by the profits of the put option.  Investors may benefit from utilizing options to protect their portfolio, but hedging strategies come at a cost and investors should weigh the costs of the hedge against the potential benefits.  Additionally, it is important to keep in mind if the stock price exceeds the strike price of call options, it is likely those options will be exercised, and you will have to sell the stock and trigger the gain on the sale.

Not only will investors find ways to generate liquidity and diversification through the means mentioned above, but a higher tax on capital gains may even encourage investors to hold their investments until death and receive a step up in cost basis.  The stepped-up basis at death allows the cost basis of an inherited asset to be stepped up to its value at the time of the original owner’s death, reducing the capital gain liability for the individual inheriting the asset.  This can be a very tax-efficient way to accumulate and pass on wealth to next generations.  For example, let’s say an individual buys 1,000 shares of stock at $10 a share for a total cost of $10,000 and leaves them to their heir.  If the stock is worth $100 per share at the individual’s date of death, the legatee’s cost basis would now be the current market value of $100 per share.  The appreciation from $10 to $100 would not be taxed, and any future capital gains taxes paid in the future would be based on the $100 per share cost basis.

The step-up in basis provision is widely criticized as a loophole for the ultra-wealthy.  Although the Biden administration had previously proposed eliminating the stepped-up basis at death, the most recent proposal contained no such provision.  Additionally, there would be many administrative challenges in implementing an elimination of step-up such as determining when a recognition event took place (at death or when a beneficiary sold the asset) and generally tracking basis over a long period of time between owners.

Overall, a higher capital gains rate may seem like an easy solution to raising tax revenue, but it can come with many adverse effects as well.  Whether an investor borrows against their portfolio, hedges the portfolio, or simply holds the assets to death, the options wealthy individuals have available to defer gains could potentially lead to being a tax revenue detractor rather than a revenue enhancer.  Not only do individuals have options to defer gains, but a higher capital gains rate may discourage risk taking and entrepreneurship, which could lead to slower economic growth.

Tax Loss Harvesting Investment Strategy

For many individuals, borrowing, hedging, or waiting to receive a step up at death may not be an option and realizing gains is unavoidable.  In this case it may be wise to consider a tax-loss harvesting strategy.  Tax loss harvesting is the process in which an investor sells investments within a basket of securities at a loss, while simultaneously replacing them with different investments that have similar characteristics.  This enables the investor to maintain their market exposure and generate losses to help offset any capital gains.  Replacing investments with different investments is critical to avoiding a “wash-sale” in your account.  Wash-sale rules prohibit investors from selling a security at a loss, repurchasing the same security again immediately, and then realizing those capital losses.  Investors must wait 30 days to buy the same security back to realize the loss.  Because of wash sale provisions, investors may want to consider investing directly in a separately managed account (SMA) with a tax managed investment objective.

Let’s examine the differences of investing directly in an exchange traded fund (ETF) versus a tax managed separately managed account investment strategy.  Exchange traded funds are a type of investment vehicle that can be traded on an exchange like a stock and are designed to track an underlying index by replicating the weights of all the underlying stocks that make up a particular index.  Separately managed accounts are a type of investment structure where a portfolio manager has discretion to be selective in what stocks may be held.  The important difference is that an exchange traded fund investor owns shares of the investment vehicle (ETF) that in turn owns shares of underlying companies, giving the investor indirect ownership of the underlying securities.  On the other hand, in a separately managed account, the investor owns the underlying investments outright in their name.

To illustrate this concept further, if an investor were to invest in the iShares S&P 500 exchange traded fund, they would have received an annual return of 18.37% for calendar year 2020, but unable to take advantage of any tax-loss harvesting opportunities for certain securities in the portfolio that declined in value over the year because of the structure of the fund. Exchange traded funds are mandated to adhere to the stated benchmark constituents and weights.  Alternatively, a tax managed separately managed account can provide investors with index-like exposure but provides added flexibility around the management of the holdings.  This flexibility allows the SMA investment manager to harvest losses, while continuing to mimic the exposure of the underlying index. As outlined in figure 3 below, while the index produced an annual return of 18.37%, there were over 190 names within that index that had negative returns for the year.

Figure. 3: 2020 Total Return of companies comprising SPY Index

Source: Bloomberg

To take advantage of this opportunity set, tax managed portfolios will initially invest in a limited number of securities.  In our example of the S&P 500, the initial portfolio may only hold 250-400 of the securities that comprise the S&P 500, which enables the manager to mimic sector weights and risk exposures to the index.  After the initial portfolio is constructed, over time, the tax lots exhibiting losses will be sold and replaced with newly purchased securities with similar characteristics.  As changes are made, care is taken to ensure the portfolio still resembles the intended benchmark with regards to performance correlation and other factors such as yield, market capitalization and sector exposures.  The intended result of this process is a portfolio designed to track a stated index, while producing realized losses.  These losses can be used to offset gains that an investor may have elsewhere in their overall portfolio.

Not only are these strategies effective in minimizing capital gains taxes, but they can also be a useful tool for investors who hold large, concentrated stock positions.  Realizing losses in the tax managed portfolio will allow an investor to sell portions of the concentrated stock position over time while minimizing the tax burden and reducing the concentration risk.  In turn, the investor can then reinvest the proceeds from the sale of stock into the tax managed strategy to further diversify their investment portfolio.  Over time, this also allows an investor to shift their cost basis away from a single concentrated stock into a fully diversified portfolio.

In summary, given the multiple alternatives that investors have available to delay or avoid paying capital gains taxes, an increase in the capital gains rate from 20% to 25% for higher earners is unlikely to generate as significant a source of tax revenue as expected.  Before considering the alternatives outlined in this paper, you should consult with a knowledgeable advisor and tax professional.  The Wealth Advisors at Round Table Wealth Management have the experience and expertise to help clients navigate numerous tax and financial concerns.  To learn more or speak with an advisor, please CLICK HERE.


[1] Hypothetical growth rate of 7%; and margin rate of 4.25%

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