Many are asking if they should realize gains early, or defer and possibly pay more next year. Here’s what we’re telling our clients.
Thomas McGraw, Managing Director, Advice Lab
Ever since President Joseph R. Biden won the election on a platform that included raising tax rates on the wealthy, our clients at the Private Bank have been asking us: Should they realize income soon, while long-term capital gains tax rates are still low, and perhaps before the market prices in the impact of expected tax hikes?
That question is more urgent now that President Biden has unveiled his American Families Plan, which proposes raising the top U.S. tax rate on long-term capital gains (LTCG) from 20% to 39.6% for households making $1 million or more.
Many will want to decide soon whether it would be better for them to throw out the playbook and pay taxes early on their gains, or defer payment until later, when tax rates may well be higher. This decision may have the greatest consequences for owners of concentrated, low-basis positions in publicly traded stocks, as their LTCG tax bills could be the highest.
Because we help our clients think through what would be best for their specific situations, given their portfolios and long-term goals, you should reach out to your J.P. Morgan team as you consider your possible options. To get the conversation started, however, we do have some initial recommendations.
What we’re telling our clients
Uncertainty remains over what, if anything, Congress will do about the LTCG rate. Biden’s proposal is just that: a proposal. We consider it unlikely he’ll get enough votes in Congress to increase the LTCG rate to 39.6%. It is more likely, we believe, that any increase would likely take the LTCG rate up from the current 20% to somewhere in the 25% to 28% range. However, it is entirely possible there will be no increase. And if that’s the case, a premature recognition of gains would be uneconomical.
Our analysis uncovered some important guidelines. Based on the realistic assumptions we’ve built into our models, should the LTCG tax rate increase and the price of a stock in a portfolio appreciate (no matter by how much), a taxpayer would generally be better off selling this year versus next (all else equal). But take note: How much better off the taxpayer would be is a function of how much rates increase and how much embedded gain the position already has.1
This caveat should be considered: The main scenario in which it may make economic sense to sell next year with higher rates is one in which the stock price drops between now and then. Our analysis finds that the higher long-term tax rates increase and the lower your basis in the shares, the more precipitous the drop would have to be for it to make sense to wait until next year to sell. Irrespective of a potential tax rate change, if investors think a position is going to depreciate in price over time, they should generally sell it.
Market reaction is unclear. News of a possible increase in the LTCG rate had not, at the time of writing, significantly affected stock prices. Does that mean market participants are unsure Congress will actually pass a rate increase? Or do investors believe that higher rates would not meaningfully impact overall stock market profitability? It’s unclear. Maybe the latter. After all, according to the Tax Policy Center, only about 25% of U.S. equities are owned in taxable accounts, the only place in which a change in the LTCG rates would have an effect. (The remaining 75% is spread across foreign holdings, retirement accounts and institutional nonprofits.) Changes in corporate tax policy are likely a bigger headwind to the market than a higher long-term capital gains tax rate.2
For you, other factors may be more important than the LTCG rate. We strongly advise against making any investment choices based solely on your view of short-term political outcomes, which is what a decision to sell based exclusively on a prediction of what LTCG rates next year would be. You are far more likely to achieve your long-term goals if you take a larger view of the fundamentals of the economy as a whole, markets generally, specific sectors and business trends, specific company management and outlook, and the principles of diversification.
Study your individual situation before acting. An analysis of your holdings and goals would help you evaluate your best moves now. Your J.P. Morgan team is armed with an understanding of your personal objectives and the markets, as well as our proprietary tool that can help you quantify your options regarding long-term capital gains. In general, the below seven key decision factors will help you determine whether it makes sense to consider selling now or later, if ever at all.3
While looking at your whole picture...
We also suggest taking into account the potential impact that other proposed tax rate changes now on the table may have on you. The American Families Plan also proposes changes to:
- Ordinary income tax—The Plan proposes to increase the top ordinary income tax rate from 37% to 39.6%, though it is unclear at what income level that top rate would apply. Current White House statements indicate the proposed increased rate bracket would apply to single filers with incomes over $452,000 and to joint filers with incomes over $509,000, but that is a detail Congress will have to negotiate as an actual bill comes together. Such an increase in the top ordinary income rate would affect numerous high-income taxpayers, including those who earn compensation in the form of high salaries and cash bonuses, the vesting of restricted stock units and exercise of non-qualified stock options, as well as owners of profitable businesses organized as “pass-through” entities (such as partnerships).
- Step-up in basis rule—The Plan proposes largely doing away with the step-up in basis rule,4 though it is not clear whether that simply means inheritors would take a decedent’s basis in assets received at death, or whether death would be deemed a taxable event. Notably, the Plan does not presently propose reducing the gift or estate tax exclusion amounts (now $11.7 million per individual).5
- Carried-interest tax/Like-kind exchange deferral—The Plan would tax the carried-interest income of private equity managers and other investment principals as ordinary income, instead of capital gains. It also would limit “like-kind” exchanges (in which real estate investors defer gains when they swap properties). This benefit would be capped at $500,000 of gain deferral, which would undoubtedly change how many commercial real estate transactions are done if enacted.
Anytime a president proposes meaningful changes to the law, tax-related or otherwise, those proposals merit serious consideration and analysis. Ultimately, however, Congress passes laws, and the legislative process around these tax matters has only just begun.
Expect many headlines as lawmakers debate the merits of these and other related ideas during the next several months. But there will likely be no resolution until the end of the summer—at the earliest. Your J.P. Morgan team will keep you apprised of the legislation and your opportunities.
1 In this context, the additional long-term factors to consider beyond this near-term rate change modeling exercise are: (1) whether the step-up in basis at death rule is repealed and, if it is, (2) the amount of any estate tax exclusion that would be available to the decedent, (3) whether inheritors would simply take the decedent’s basis (as opposed to the decedent’s death being a realization event for income tax purposes), (4) the relative estate and long-term gains tax rates, and (5) the length of time of the analysis.
3 This tool helps determine—based on U.S. and state long-term gains rates, now and in the future—how much better off a taxpayer might be by realizing gains now at a lower rate as compared to at a higher rate in the future. There are multiple factors that could impact the result, including the expected total return on the reinvested proceeds; the volatility of the stock being held; the current embedded appreciation in the position; and the exact effective LTCG rate, which could vary significantly for a taxpayer in a state that imposes an independent income tax depending on whether, as has been proposed, the cap on the deduction for state and local taxes (paid) is lifted.
4 The step-up in basis rule is where the cost basis of assets included in a decedent’s estate are “stepped up” or reset to the fair market value as of the date of death, thus eliminating any embedded gain the decedent had in the position prior to passing.
5 Under current law, if left unchanged, the doubled exclusion amount is scheduled to sunset on December 31, 2025, at which time it will revert to the pre-2018 amount of $5 million, adjusted for inflation.