Is Now a Good Time to Pay Capital Gains Taxes?

So far, 2020 has been a banner year for investors. Hopefully, the stock market rally has led to capital gains in your portfolio.  If so, you may be wondering whether it might make sense to pay taxes on some or perhaps all of those gains before possible tax law changes that could result from the election of Joe Biden as President.

Typically, accelerating the taxation of capital gains is ill-advised because cash used to pay taxes cannot be invested.  In addition, the tax code currently provides for the tax basis of inherited securities to be adjusted to fair market value on the date of death.  As a result, heirs may never have to pay income taxes on gains that accrued, but not realized, during a deceased investor’s lifetime.

That being said, there could be an advantage to triggering capital gains in 2020.  That’s because President-elect Biden has proposed increasing the capital-gains tax rate for high net-worth individuals from the current 20% to 39.6%.  As originally proposed, Biden’s tax plan would only raise tax rates for taxpayers with more than $1,000,000 in taxable income in a given year.  However, several of Biden’s cabinet nominees have argued for raising taxes on lower income individuals as a way to provide funding for new social programs.

The Biden tax plan would also eliminate the so-called “step-up” in basis at death.  Instead, death would be treated as a taxable event and trigger the taxation of capital gains in assets that are owned at the time of death all at once.  If President-elect Biden’s proposal is adopted, there would no longer be a tax advantage to refrain from selling appreciated assets during life.  Rather, lifetime tax recognition would be helpful to heirs because (i) money used to pay taxes prior to death would not be subject to death taxes, and (ii) taxing capital gains on inherited assets in a single year could push the heir into a higher tax bracket.

The prospect that capital gains will be taxed more heavily in years to come means it might make sense for well-to-do investors to sell appreciated investments before the end of the year, provided that the security to be sold was owned for more than a year.  That’s because securities owned for less time than that are taxed at higher ordinary income tax rates.

That said, there are a number of reasons why in most situations the potential for higher capital-gains tax rates is probably not reason enough to accelerate capital-gains recognition for most investors.  For one, taxes incurred on capital gains realized in 2020 will have to be paid in 2021, while taxes incurred on capital gains realized in 2021 will not have to be paid in 2022. 

Secondly, tax law changes require Senate approval.  And although the Democrats could seize control of the Senate if they win both of the January run-off elections in Georgia, that seems unlikely.  And even if capital-gains taxes are raised next year, they would likely be lowered again the next time the Republicans regain control of government.

If you have already sold appreciated assets in 2020, you may want to consider tax-loss harvesting to lessen the tax bite on those gains.  This is a strategy of  selling a security at a loss to create a capital-loss deduction and reinvesting the sale proceeds in a similar, but not “substantially identical”, investment. 

Capital-loss harvesting can be advantageous because realized capital losses can be subtracted from capital gains, allowing you to lower your current tax bill and leaving more money to invest.  Furthermore, harvested capital losses can also be used to offset up to $3,000 of ordinary income.

Then again, it’s important to recognize that in most cases tax-loss harvesting does not eliminate capital-gains taxes but only defers them.  That’s because the replacement security you buy will have a lower tax basis than the one you sold.  As a result, the tax savings you enjoy today may result in a corresponding increase in taxes tomorrow.  So, tax-loss harvesting could backfire if your tax rates do go up.

Thank you for reading,

Andrew J. Willms, JD, LL.M.