Being an accountant doesn't mean you're giving investment advice to clients. However, at tax time, accountants often have to deal with the results of any investment advice clients obtained during the year—the good and the bad. So it's a good idea for accountants to acquaint themselves with some key tax-related investment issues—especially when it comes to the deceptively tricky cap gains rules.
Let's start with the basics. Take a client who sells an investment that she has owned for more than 12 months, any increase in its value from its cost basis is taxed at her long-term capital gains tax rate. This is 15 percent for most individuals, but can go as high as 23.8 percent for those in the top income-tax bracket of 39.6 percent, who are subject to the 3.8 percent Medicare surtax on investment income.
It can get worse for our client: She surrenders more to the IRS when her profit is from the sale of an asset held for less than 12 months. Her short-term gain is taxed at the higher rates applied to ordinary income from sources like salaries and pensions.
Here's the problem, at the nexus of tax law and investment strategy: Should savvy investors opt to realize short-term gains, so as to nail down profits, albeit causing them to be nicked for taxes at the same rates as ordinary income? Or is the wiser strategy to stand pat until those profits become long-term, meanwhile hazarding declining prices that more than offset the lower taxes?
To illustrate the alternatives, assume that Norma Bates' regular income-tax bracket is 25 percent (for 2014, taxable income between $36,900 and $89,350 for singles and between $73,800 and $148,850 for joint filers). Norma has a sizable unrealized gain on shares of Beefsteak Uranium, a volatile stock she has owned for fewer than 12 months. She's considering selling her BU shares for fear of plummeting prices caused by terrorist attacks or world instability. Her worst fear: photos of BU's top execs being booked on charges of securities fraud and larceny—for instance, cooking the books, spending company funds on personal indulgences (like the infamous $6,000 shower curtain for the home of L. Dennis Kozlowski, the fired and convicted chief of Tyco International Ltd.), or other kinds of corporate chicanery.
Without getting into the issues of price volatility and potential market shocks, Norma has two options for that kind of short-term paper profit. The first option is to unload the shares now and secure the short-term gain, but suffer the loss of 25 percent of the gain to the IRS. Plus, depending on where she lives, she may also owe state and even city taxes on this money. The other option is to hold off on a sale until the gain becomes long-term, and forfeit no more than 15 percent of it to the IRS, plus local levies. The drawback, as noted, is a price drop that exceeds the taxes saved.
How much of a drop can Norma endure while waiting until she qualifies for the lower rate and still be no worse off after taxes? For the answer, she uses the following three-step formula:
- Figures her after-tax return on the short-term gain.
- Divides this amount by her after-tax return on the same amount of long-term gain.
- Multiplies the short-term gain by the resulting percentage.
The result shows how much the price can drop, yet permit Norma to keep as much after taxes from a smaller long-term gain as she would from a larger short-term gain.
To make the math less formidable, suppose Norma's paper profit is $10,000. Her combined federal and state brackets for gains is 30 percent for short-term and 20 percent for long-term. A $10,000 gain (after any sales expense) taxed at 30 percent entitles the tax collectors to $3,000 and leaves Norma with $7,000. The same $10,000 taxed at 20 percent leaves her with $8,000. Divide $7,000 by $8,000; the resulting percentage is 0.875. Multiply $10,000 by 0.875 and the result is $8,750. A smaller long-term profit of $8,750 taxed at 20 percent leaves Norma with $7,000, as much as would be received were she to sell for a $10,000 gain and be taxed at 30 percent.
Given those numbers, when does a decision to sweat out the 12-month holding period leave Norma worse off after taxes? Not until her paper profit drops from its present $10,000 to below $8,750—that is, by more than $1,250.
About the author:
Julian Block writes and practices law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator) and an attorney. More on this topic is available from "Julian Block's Year Round Tax Strategies", available at julianblocktaxexpert.com.
About Julian Block
Attorney and author Julian Block is frequently quoted in the New York Times, Wall Street Journal, and the Washington Post. He has been cited as “a leading tax professional” (New York Times), an “accomplished writer on taxes” (Wall Street Journal), and “an authority on tax planning” (Financial Planning magazine). More information about his books can be found at julianblocktaxexpert.com.