Finding the Sweet Spot for Investor Clients

Offering investment advice is not necessarily something I recommend, especially as a tax lawyer, but when financial markets gyrate, many clients want advice about taxes, especially seemingly simple rules for capital gains.

So, if you have clients like this we need to start with the basics. Take an individual who sells an investment that they have owned for more than 12 months. Any increase in its value from its cost basis is taxed at their long-term capital gains rate.

The Tax Cuts and Jobs Act lowered the seven rates for ordinary income and retained the three rates of 0, 15 and 20 percent for capital gains. All of those rates apply for calendar years 2018 through 2025. They go off the books after 2025.

Our lawmakers decided to apply capital gains rates by using “breakpoints.” They aren’t strictly aligned with the new brackets for ordinary income that go as high as 37 percent.

For single individuals, the rates are:

  • 0 percent on income of up to $38,600
  • 15 percent on income between $38,600 and $425,800
  • 20 percent on income above $425,800

For joint filers, the rates are:

  • 0 percent on income of up to $77,200
  • 15 percent between $77,200 and $479,000
  • 20 percent above $479,000

The rates go as high as 23.8 percent for those who are in the top income-tax bracket of 37 percent and subject to the 3.8 percent Medicare surtax on investment income.

It Can Get Worse

Investors surrender more to the IRS when profit gained from the sale of an asset held for 12 months or less. The short-term capital gain is taxed at higher ordinary income-tax rates—the same rates that apply to income sources like salaries and pensions.

The dilemma: 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 could more than offset the lower taxes?

Consider an example: Let’s say Norma Bates’s rate is 15 percent for long-term gains. Norma has a sizable unrealized gain on shares of Beefsteak Uranium (BU), a volatile stock she has owned for fewer than 12 months.

She’s considering selling her BU shares for fear of plummeting prices, perhaps caused by terrorist attacks or world instability (cue countries like North Korea, Iran and Russia). Norma’s worst fear: photos of BU’s top execs being booked on charges of securities fraud and larceny, a result of cooking the books, spending company funds on personal indulgences or some other kind of corporate chicanery.

Her first option: Unload the shares now and secure the short-term gain, but lose 22 percent (her rate for ordinary income) of the gain to the IRS. Depending on where she lives, she may also owe state and even local taxes on her profit.

Her other option: 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.

How much of a drop can Norma endure while waiting until she qualifies for that lower rate and still be no worse off after taxes? For the answer, she can use this three-step calculation:

  1. Figure her after-tax short-term profit from her BU shares
  2. Divide this amount by her after-tax profit on the same amount of long-term gain
  3. Multiply the short-term gain by the resulting decimal

To see how the math works, let’s plug in some numbers. Suppose Norma’s paper profit is $10,000. Her combined federal and state bracket is 30 percent for short-term gains. For long-term gains, it’s 20 percent:

  • A $10,000 gain taxed at 30 percent entitles the tax collectors to $3,000, leaving Norma with $7,000.
  • The same $10,000 taxed at 20 percent leaves her with $8,000. Divide $7,000 by $8,000 and you get 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—the same profit she would have received were she to sell for a $10,000 gain and be taxed at 30 percent.

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.

Is it worth waiting? Clients have to decide that one for themselves.

Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 250 and counting). 

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About Julian Block

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

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