Common Cents on August 31, 2018

August 31, 2018, by John Norris

I absolutely loathe the capital gains tax. It is one of the worst tax laws ‘we’ have, as it inhibits the free flow of capital throughout the financial system. Period, and end of discussion. You can make whatever impassioned argument you want in favor of it; you can produce complicated spreadsheets purporting to show the financial efficacy of the capital gains tax all you want, and I will not waver in my distaste for it.

It keeps money from flowing to its highest and best use, and you would need a pencil as sharp as a razor blade and as large as an elephant to accurately and adequately quantify its true negative impact on the whole economy.

Let me give you a simple example: assume you own 2,500 shares of, say, Southern Company (SO) with a cost basis of $3/share in a taxable account. As I type, it is trading at $43.66. While no one really expects to hit a home run with utility stocks, the higher (on average) dividend and presumed downside protection of the things make them popular with some investors. Even so, brother, you sure would like to invest in a broader array of assets; you know to diversify, and all that jazz. Recently, the SPY exchange traded fund, which tracks the S&P 500, has caught your eye.

Do you sell your SO to buy it? Assuming there isn’t anything fundamentally wrong with the company?

If you are like a lot of folks, if not most, the answer is probably not. After all, it is just math. IF you were to sell all 2,500 shares at that market price, voila, you would generate a realized capital gain of $101,650. Now, depending on your income level and state of residence, you could end up with a tax bill in excess of $25,000. Most folks who read economic newsletters would undoubtedly have NO LESS than a $20,000 tax consequence.

That is a lot of money SPY would have to make up in a pretty short period of time. Can I, or anyone for that matter, guarantee the S&P 500 will outperform Southern Company stock by 15-25% in a year? Two years? Even three? Heck, what about five?

Shoot 25% is roughly 4.5% annualized for 5 years. Will the broad market outperform SO by that amount over that time frame, or thereabouts? What if it the market returned 8% to the Southern Company’s 5% over the next five years? What then? I mean that is pretty big difference, right?

Well, not enough to make selling SO to buy SPY financially prudent….by along shot. However, your lost ‘opportunity cost,’ if I can be so bold as to use that term here, is about 16%. On that initial investment, 2,500 shares times $43.66, that works out to be about $20,000.

You are just going to have to trust me on the math, but I promise you I did it. The sneaky truth here is you would have to outperform SO by 7.5% annualized for five years for it to be an after-tax wash.

In the end, you hold onto your SO to avoid paying the tax which would cripple your return. So, the government doesn’t get the revenue AND you don’t get the market’s full upside potential. Awesome! NO ONE WINS! Hey, this isn’t any speculation on my part. I have seen this play out numerous times throughout my career with a number of different stocks.

Again, I loathe the capital gains tax.

This week, the Administration announced it was considering adjusting cost bases for inflation. That seems simple enough, but the devil is going to be in the details. It was/is hard enough just to get historical cost information from old brokerage statements, let alone trying to calculate the CPI (consumer price index) on the investment from the date of purchase. Or should it be settlement date? Regardless, your cost basis in your SO is, what did I say, $3. Do you know what day your, let’s assume, grandmother purchased it? The month? Heck, can you at least take a stab at the year?

Now, imagine that scenario and multiply it by, how about, 20 holdings per portfolio times how many individual investors across the country? All with different positions, tax lots, and purchase dates. What about holdings in DRiP programs? Then you have to factor in mergers, acquisitions, stock dividends, splits, reverse splits, and all of those dates. What about private and other investments for which there isn’t a liquid, transparent secondary market. Real estate which has been in ‘the family’ for generations? Do you have all those documents and proof of purchases? Cancelled checks, receipts and the like showing the exact day of purchase? Can we even get a good inflation number for assets which have been floating around for over a century? How can we calculate a substitution basket for inflation for time periods prior to the creation of the CPI? Whew…the mind starts to boggle.

I understand the technology is probably ‘out there’ to do all this, but ‘indexing for inflation’ isn’t and will not be as easy as it may seem. To that end, and with that in mind, I am going to let you in on a little secret: it, whatever it may be, probably isn’t as automated as you might think. I am just saying.

Don’t get me wrong, I believe any weakening or softening of the current capital gains tax rules is a step in the right direction, a big step. However, as simple as this sounds, is this it? Or does it create too much of an accounting nightmare? Moving forward, the answer is probably: this could be a good idea with a little elbow grease and investment. Looking backward, this could very well be a Herculean undertaking. As with everything, the devil is in the details.

Personally, and I freely admit no one has asked for or otherwise solicited my opinion, why not just cut the capital gains tax rates? While I would personally advocate for eliminating this pernicious tax completely, I imagine there is little stomach for doing such a thing in Washington…for any number of reasons. In fact, I doubt we will see any substantive change to the capital gains tax rate any time soon.

The reason(s) why? Well, there would be any number of folks who would want to hide behind a rich vs. poor argument. That the capital gains tax is a progressive tax, as only the rich have to pay it. At least that is the underlying thought process, assuming, that is, you think a family making $77,400/year and an individual making $38,700 is/are rich. As an aside, short-term capital gains are taxed at your marginal tax rate, so we are talking about long-term rates here.

However, the truth here is stranger than fiction, or should I say maybe uglier. I will be blunt: there are a lot of people and industries who make a lot of money devising tax avoidance strategies and the like. The capital gains tax is just part of a big puzzle. How many times have I made a recommendation to someone to, say, pay their church pledge with a low-cost basis stock holding as opposed to cash? Or gift said same to a child? Recommended considering creating a family LLC for a private investment that has the potential to grow exponentially? You know, that sort of thing? I will spare you: a lot, and I am just one person in a multitude of other industry professionals, attorneys, CPAs, etc.

Basically, there is a substantial financial incentive for a lot of people in keeping some form of capital gains tax. As long as there is, well, I think you get the picture. Me? I want it gone even if doing so would negatively impact our business on the margins.

In closing, this week the Administration started a discussion about reforming the capital gains tax. While that is certainly a step in the right direction in removing what I consider to be a form of capital control, I am dubious anything meaningful will happen prior to the November elections. There are too many reasons, read dollars, to keep it in place and too few people in Washington willing to fight for what much of the country considers a tax on the rich….especially right before what proves to a contentious election year.