Pending tax changes affect portfolio management

(MoneyWatch) If the Bush-era tax cuts expire as scheduled at year-end, the tax rate on long-term capital gains would rise from 15 percent to 20 percent, and gains of high-income investors would be subject to an additional Medicare tax of 3.8 percent. Rates on ordinary income tax are also scheduled to rise, and a higher Medicare tax rate will apply for high-income earners. These changes should impact how you think about tax management of your investment portfolio for the rest of 2012.

Knowledgeable investors use loss-harvesting strategies to enable them to reduce their tax bill. Capital losses can be used to offset both long- and short-term gains, and up to $3,000 of ordinary income. Obviously, losses have more value when used to offset short-term gains and ordinary income, since those types of income incur higher tax rates. When capital losses are used to offset long-term capital gains, the value of the losses is basically limited to the time value of money (your opportunity cost of capital). The reason is that when you sell and repurchase the same security 31 days later (or buy a similar security immediately), you reset your basis to a lower level. When you eventually sell, your gain will be taxed from that lower basis.

The higher tax rates set to take effect in 2013 should give you pause before harvesting losses, especially if they'll be used to offset long-term gains currently taxed at 15 percent. If you wait until next year, the loss will have greater value since long-term rates are scheduled to be 23.8 percent.

The potential increase in taxes gives rise to another possible change in strategy. The conventional wisdom has been that investors should delay realizing gains as long as possible. However, with the capital gains rate expected to increase, intentionally realizing gains in 2012 can make sense. First, you would pay taxes at the current rate of just 15 percent (instead of 23.8 percent). Second, when you buy back the same security, you reset your basis at a higher level, increasing the potential to harvest losses -- and those losses will have greater value at higher tax rates.

Factors to Consider

When considering whether to harvest losses, there are four factors you need to consider:

  • Tax rate on the income being offset by the harvested losses
  • Expected tax rate when the reacquired assets will eventually be sold
  • Time value of money -- your opportunity cost of capital
  • Length of the period you intend to hold the replacement security before selling it -- the longer the period, the more valuable the harvested loss

When realizing gains early the two factors to consider are:

  • Difference between the current and future expected tax rates
  • Length of the period you intend to hold the security before selling it -- the longer the period, the less valuable the savings achieved by paying taxes early, but at lower rates. If you would be selling the security anyway within the next few years, it's highly likely that you would be better off intentionally realizing the gain in 2012. However, if your horizon was perhaps 10 years or longer, you might consider waiting (though you run the risk that rates could go even higher than currently projected).

The bottom line is that the potential changes in tax rates provides for the opportunity for investors to do some intelligent tax planning. While none of us has a clear crystal ball as to outcomes, doing the mathematical analysis needed to decide on the right strategy will help you prepare to make good decisions before the end of the year. Helping with these issues is one way a good financial advisor adds value. And, as always, the prudent thing to do before taking any action is to check with your CPA or other tax advisor.