Biden’s Capital Gains Tax Increase No Big Deal

President Biden proposed increasing the capital gains tax and while that makes great headlines, it probably isn’t as big of deal as it sounds like.

First off, the higher tax would only apply to those with income above $1 million. That takes out most taxpayers right there.

Avoiding Capital Gains Taxes

Also, capital gains is one of the easiest to avoid taxes. Most people hope to never lose that much money, but there are plenty of losses to be had even by the best investors. Matching those losses up to gains is called tax-loss harvesting and is frequently used by those with large enough investment portfolios to eliminate some or all of their capital gains taxes.

Biden's Capital Gains Tax Increase No Big Deal 1

Imagine a scenario where a wealthy investor purchases ABC stock and XYZ stock. A clever investor would make sure that ABC stock and XYZ stock pay an acceptable dividend based on their risk and expected return. So, over a couple of years, our investor collects his dividends. Since the only way this new tax applies is if the investor has $1 million in income, they will pay the highest dividend tax bracket of 20% tax on the dividends, still far lower than the 39% income tax bracket.

Now, over those few years it turns out ABC stock has had a tough couple of years resulting in say $100,000 worth of losses. At the same time, the timing was right on XYZ stock and the investor is ready to sell with a $100,000 gain. The investor then also sells the ABC stock resulting in zero dollars of gains for tax purposes.

The investor need wait only 30 days to repurchase ABC stock if they wish to avoid wash sale rules. To cover any possible explosion in ABC stock, the investor can purchase another stock that is highly-correlated with ABC stock, or even an ETF fund that is highly influenced by the price of ABC and other similar stocks.

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For example, an investor selling Lyft might pick up shares of Uber as a way of catching any rapid upside in on-demand delivery companies. An internet-technology ETF might be a similar way to play the upside. Options are often used for this strategy, although you can’t just buy options in ABC. The investment has to be substantially different.

The great part (bad part for the IRS) is that these sales don’t have to be paired in any real way. The investor could sell XYZ when they desire in March, and then wait all year long to see if ABC recovers, or if another stock falls in a way that makes it more desirable to match up with the XYZ sale. In fact, many investors will simply buy and sell without regards to taxes throughout the year, and then go through their portfolio at the end of the year to find losses.

In fact, one of the most common ways high-net worth investors avoid capital gains is that they will have one or two very large positions that have losses. They sell those one or two positions, and that overall loss wipes out dozens of other positions sold for gains. If the losses are big enough, the investor can carry them forward to wipe out capital gains losses in future years. Those losses can be carried forward forever. Have you heard about Donald Trump’s $900 million tax write off from his disastrous casino business? His taxes show that he’s been writing off all of his investment income against that one loss ever since.

No Sale, No Gain

The other thing to remember is that no matter how much a stock price goes up, and no matter how big those green numbers get on your brokerage statement, there is no capital gain until you sell. That Berkshire Hathaway stock an investor bought years ago is probably worth millions more, but unless they sell, they never pay tax on that position. In fact, the smartest investors simply hold those kind of positions, continue to earn any dividends, and if they’d like to make some other investments, use that highly-appreciated stock value as collateral for low-interest loans, or margin account collateral.

Either way, capital gains are the one tax that you only pay when you want to.

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