Common Cents & Capital Gains Taxes on June 28, 2019

June 28, 2019, by John Norris

Yesterday, a few headlines reported the Administration was/is mulling a somewhat convoluted way of reducing the capital gains tax by indexing said gains to inflation, skirting a dubious Congress in the process. Nefarious stuff, that. The original source of the breaking news was a story on Bloomberg which cited, no kidding, “according to people familiar with the matter.” To seemingly add veracity to the story was the clincher: “A White House spokesman didn’t immediately respond to a request for comment.” The author didn’t provide a definition of immediate or immediacy.

Perhaps not surprisingly, all the articles pointed out this turn of events, if they are indeed true, was largely a break for the wealthy. After all, intuitively, it is the wealthy among us who have the means necessary to invest in assets which would or could have a capital gains tax consequence. The rich get all the breaks, all the time, don’t they? Huh?

After reading the source story a few times, I had a few observations, questions, and concerns: “my, but isn’t this a thin soup? What is the actual calculation? What are the marginal tax rates? Who pays it? Do people ‘familiar with the matter’ have any details on which I could base an opinion on the Administration’s plan?”

Inquiring minds what to know!

I will cut to the quick: I don’t really need to know any of that, as I loathe the capital gains tax, absolutely loathe it. If the Administration is mulling tweaking the formulas, it isn’t doing what needs to be done, which is eliminating them. It is a green-eyed, punitive tax which serves an indirect capital control. Did I mention I don’t like it? Hey, some people base their votes on Issue X. Others do so on Issue Y. Me? Over time, I have come to realize THIS might be my big issue.

You see, I have been in the investment industry longer than some of our employees and all of our summer interns have been walking the Earth. Over this time, I have seen any number of investment portfolios which hold ‘low cost’ concentrations of various stocks which the client is hesitant to sell, and for good reason.

Let me give you a somewhat common example/illustration in bullet points:

  • Investor A is 50 years of age.
  • Their grandparent(s) gave them 100 shares of XYZ stock when they were born. For my purposes here, I am going to use Coca-Cola (KO), as it is a common culprit in the Deep South.
  • On 6/30/1969, this would have been a very generous $6,950 gift.
  • Over the years, due to stock splits (etc.), the original 100 shares have grown to 9,600 shares.
  • The current market price for KO as I type at 12:04 pm CDT on 6/28/2019 is $51.14/share.
  • As such, the current market value of the grandparents’ gift in 1969 is NOW worth, get this, $490,944.
  • Obviously, the unrealized gain from the original gift, in nominal terms, is $483,994.
  • In Alabama, the capital gains tax bill on selling 100% of this investment would be no less than $96,789 for any client with an AGI in excess of $39,376.

Now, imagine Investor A has stumbled across an investment which could/should outperform KO by 2% per year for the next 10 years. Do they sell their KO in order to invest (assuming a 15% Federal gains tax rate and another 5% for Alabama)? Hmm? I will spare the suspense, as I have already done the math.

If the time horizon is 10 years, the answer is NO. It would not make sense for Investor A to sell their KO in this example, pay a 20% tax on the realized gain, and invest in the higher performing asset. That is unless Investor A believes KO will actually underperform by greater than 2% per year over the next decade. Really? Yes.

If we assume the new investment generates AT LEAST a positive 2% annual rate of return over the next decade, which would be absolutely dreadful by the way, it would take a minimum of 12 years to ‘break even,’ a minimum. You see, investing gets hard when you dig a -20% hole for yourself.

As a result, Investor A doesn’t make the trade. The government doesn’t get the tax, and the worthy investment doesn’t get the money. Who wins here? The only possibly winner, if you want to call it that, is the underperforming asset which doesn’t actually, well, win anything. Please note: this example is NOT a speculation or analysis of the future performance of KO, as I am solely using it as a ‘placeholder’ in this instance.

Now, multiply this little scenario millions of times over, and use much larger dollar amounts than the figures I used here. The end product is, quite literally, hundreds of billions of dollars in assets which are essentially frozen because investors don’t want to pay a substantial tax for generating liquidity on/in their balance sheet.

This is completely understandable because: 1) no one really likes paying taxes; 2) it is incredibly difficult to guarantee one investment will perform better than another, if not unethical, and; 3) it is even more difficult to guarantee one investment will perform better than another over a specified period of time BY an amount which would nullify the effects of the tax.

Compounding the problem is the fact, unlike in the example with KO stock, most people (if not all) aren’t willing to wait a full 12 years to get to ‘break even’ or ambivalence between two investments. My experience suggests the time horizon is somewhere between 18-36 months. Think about it (using our example): “sell my stock and wait 12 years just to get to where I’d be had I just held onto it? Um, no thank you. What in the [heck] is the point in that?”

The thing with the capital gains tax is the higher it is the more people will actively avoid it. Sometimes, if not more frequent than that, this will lead to bad INVESTMENT decisions which produce favorable net results after taxes. Ordinarily, this comes in the form of doing nothing at all. The money remains invested as is, and isn’t deployed to its highest and best use in the financial system and/or economy. Shoot…let the rest of us have it if you don’t want it Mr. Revenuer.

I hope this makes as much sense to you as it does to me. Then there is the whole idea of ‘tax breaks for the wealthy’ when it comes to adjusting capital gains tax rates lower. This will be a shorter discussion/analysis.

Assume you are subject to a 15% Federal capital gains tax rate and 5% at the state level. Only under dire circumstances would you consider selling your long-term ‘winners,’ your core holdings if you will, due to the tax consequences. So, you hold onto them and pay no tax. Then, Washington decides to cut your marginal capital gains tax rate to, say, 5%. This is more acceptable to you, and you sell some ‘stuck in the middle’ securities to buy some higher growth ones. Obviously, you now pay the tax.

So, in this example, is a reduction in tax rates a true reduction or break in taxes paid? Understanding you weren’t paying the tax previously, but are now due to the lower rate. The answer is pretty obvious: no, a thousand times no. A reduction in marginal rates is not necessarily a reduction in the amount of tax actually paid. This seems to be a very difficult concept to understand.

In the end, is the Administration cobbling something together to reduce capital gains tax rates? Maybe, but I am not sure I would bet more than $1 of my own money or $20 of yours based on the source story I read on Bloomberg. Even so, if President Trump IS serious about cutting this pernicious tax, and I do find it pernicious, I hope he CUTS it and doesn’t tinker around on the margins like the story implies.

After all, the more money is allowed to flow through the economy, the more hands it can touch.

 

Have a good weekend

John Norris