By Robert S. Keebler, CPA, MST, AEP (Distinguished)
Bracket management has always been an important part of income tax planning. As we noted in our May newsletter, however, the 3.8% Medicare Surtax and higher tax rates make it even more important in 2013. We listed the following strategies that taxpayers can use to avoid the surtax and stay out of the higher tax brackets: (1) Income smoothing CRTs; (2) income shifting CRTs; (3) using NIMCRUTS as a substitute for or supplement to a retirement plan; (4) CLATs; (5) Life Insurance; (6) deferred annuities; (7) installment sales; (8) managing IRA distributions; (9) loss harvesting; (10) gain harvesting; (11) Roth IRA conversions; (12) converting passive business activities to active activities by changing grouping elections; (13) private split dollar insurance; (14) reverse mortgages; (15) low NII investments; (16) real estate investments; (17) oil and gas investments; (18) choice of filing status; and (19) increasing above-the-line deductions.
While some of these strategies, like Roth IRA conversions, income-shifting CRTs, retirement plan NIMCRUTs and deferred annuities require a long period of time to produce their benefits, others can be used as year-end planning strategies. Included in this latter category are gain harvesting, loss harvesting, increasing above-the-line deductions and income smoothing CRTs. In this newsletter we will take a detailed look at gain harvesting.
For married taxpayers filing jointly, the long-term capital gains rates are as follows:
Income < $72,500……………………………………….0%
Income $72,501 – $450,000……………………………15%
Income > $450,000……………………………………..20%
Unless the capital gain is from the sale of active business assets, it is treated as net investment income (NII) and may also be subject to the 3.8% Medicare surtax, depending on the taxpayer’s modified adjusted gross income (MAGI). Thus, the total tax on long-term gains could vary from 0% to 23.8%.
The significant difference in rates might make it advantageous for clients to harvest gains in the current year if they expect a higher rate to apply in later years. This might be true for both high income clients and for clients with more modest amounts of income.
Example 1. Mark and Helen are married taxpayers filing jointly. In 2013 their salaries total $350,000 and they have no other income. In 2014 they expect their income to increase to $450,000. Mark and Helen own XYZ stock with a basis of $50,000 and a FMV of $150,000 that they planned to sell in 2014. If they sell the stock in 2013, the $100,000 gain will be taxed at a 15% capital gain rate. The 3.8 percent Medicare Surtax also applies to the gain, making the total tax on the gain 18.8% and the tax payable $18,800. By contrast, if Mark and Helen wait until 2014 to sell the stock, the $100,000 gain would increase their taxable income to $550,000, making it taxable at 23.8%. By selling in 2013 instead of 2014, they save $5,000 ($100,000 * (.238 – .188)). (Note that all examples assume a long-term holding period.)
Example 2. Art and Carol are married taxpayers filing jointly with total salary income of $52,500 in 2013. They own ABC stock with a basis of $5,000 and a FMV of $25,000 and expect their total income to increase to $72,500 in 2014. If they sell the stock in 2013, they will pay no capital gains tax (and no surtax). If they wait until 2014 to sell they will pay $3,000 in capital gains tax.
Reduced Tax Rate vs. Loss of Tax Deferral
Deciding whether to harvest gains at the end of 2013 is not as simple as it might appear, however, because it introduces a trade-off between paying tax at a lower rate and losing tax deferral. To analyze whether gain harvesting makes sense in a particular case, we can think of the tax paid in 2013 as an investment to buy tax savings in a later year and calculate a rate of return on the investment. We will assume that the investment is in publicly traded stock, that the sells the stock in 2013, repurchases similar stock and sells the replacement stock whenever the original stock would have been sold if the gain harvesting strategy had not been employed. The following simple example illustrates how the analysis would be done.
Example 3. Toward the end of 2013, Ann owns XYZ growth stock with a basis of $10,000 and a FMV of $110,000 that she otherwise would have kept until 2014. Assume that the stock grows in value by 6% per year. If Ann sells the stock in 2013, her total tax rate will be 18.8%, but if the stock is sold in 2014, the rate will be 23.8%. The following charts compare the economic consequences of (1) foregoing gain harvesting in 2013 and selling the stock in 2014 and (2) harvesting the loss in 2013, reinvesting the after-tax proceeds in similar stock and reselling it in 2014. Assume that in both cases Ann will have a long-term holding period for the stock.
ALTERNATIVE 1 (NO GAIN HARVESTING)
Stock Value $110,000 $116,600
Less basis 10,000
Tax @ 23.8% 25,371
After-tax value $91,229
ALTERNATIVE 2 (2014 GAIN HARVESTING)
Stock Value $110,000 $96,672
Less basis 10,000 91,200
Gain 100,000 5,472
Tax payable 18,800 1,302
After-tax value $91,200 $95,370
Ann ends up with $4,141 more in the gain harvesting alternative ($95,370 – $91,229). This makes the rate of return on the tax paid 22.02% ($4,141/$18,800). Because this is presumably far above Ann’s opportunity cost of capital, she should harvest her gains in 2013.
The 2013 gain harvesting decision is very fact sensitive. Under the facts assumed above, 2013 gain harvesting turned out to be very favorable, but in other cases it could be disastrous. The key variables are (1) the time period between the gain harvesting sale and the sale of the repurchased assets and the difference in tax rates between the two sales.
The shorter the time period between the loss harvesting sale and the second sale, the more favorable gain harvesting will be. The following chart assumes the same facts as in Example 3 and shows the effect on rate of return (ROI) for longer time horizons.
Year of Resale ROI
Tax Rate Differential
The greater the difference between the 2013 tax rate and the tax rate when the stock is resold, the greater the ROI. If the taxpayer is in the 0% capital gain bracket in 2013 and the 15% bracket in 2014, as in Example 2 above, the ROI would be infinite because no tax would be paid on the gain in 2013. In effect, taxpayers would get a free basis step up. The chart below shows the ROIs for the unusual case in which a taxpayer went from a 15% capital gains bracket in 2013 to a 23.8% tax rate in later years to illustrate the effect of the wider rate differential.
Year of Resale ROI
ROIs are also sensitive to the assumed rate of return for the stock. The higher the expected return, the lower the ROI for the gain harvesting strategy will be. The taxpayer’s opportunity cost of capital is also important because it represents the hurdle rate the ROI on gain harvesting must exceed to make it worthwhile for the taxpayer.
Caveat—Economic Substance Doctrine
The courts have long held that tax motivated transactions will not be respected unless they have economic effect apart from the tax benefits. In 2010, this doctrine was codified in IRC § 7701(o), which provides that a transaction has economic substance only if (1) it changes the taxpayer’s economic position in a meaningful way and (2) the taxpayer has a substantial non-tax reason for entering into the transaction. This Code section imposes a 20 percent penalty on any underpayment of tax from a transaction that does not pass the two-pronged test. The penalty increases to 40% if the transaction is not adequately disclosed on the return.
There are two ways to build economic substance into the gain harvesting strategy. One would be to add time between the gain harvesting sale and the later repurchase. The longer the time period between the sale and the repurchase, the greater the change in value a taxpayer could expect in the interim. If the taxpayer likes the long-term prospects for a stock, but believes its value is likely to drop in the short term, he might consider this strategy even without the potential gain harvesting benefit. A safer alternative might be to reinvest in different, but similar assets. The new assets could still fit the taxpayer’s investment strategy and there would be no need to stay out of the market for a substantial period of time.
2013 year-end gain harvesting could be very favorable or very unfavorable, depending on the facts of the case. Analyzing clients’ fact situations to determine whether they could benefit from loss harvesting might be a key part of year-end tax planning for many clients. This column provides a basic model for performing this analysis.
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ABOUT THE AUTHOR
Robert S. Keebler is a partner with Keebler & Associates, LLP. He has received the prestigious Accredited Estate Planners (Distinguished) award from the National Association of Estate Planning Counsels and has been named by CPA Magazine as one of the Top 100 Most Influential Practitioners in the United States. Mr. Keebler is the past Editor-in-Chief of CCH’s magazine, Journal of Retirement Planning, and a member of CCH’s Financial and Estate Planning Advisory Board. Mr. Keebler frequently represents clients before the National Office of the Internal Revenue Service (IRS) in the private letter ruling process and has received over 150 favorable private letter rulings. Mr. Keebler is nationally recognized as an expert in family wealth transfer and preservation planning, charitable giving, retirement distribution planning and estate administration and works collaboratively with other professionals on academic reviews and papers, as well as client matters. He can be reached at (920)593-1701 or at [email protected].