The Homa Files

Punch line: The planned (and anticipated) increases in capital gains tax rates will motivate stockholders to sell stocks and pay capital gains taxes at the current 15% rate.  As a result government tax revenues should soar between now and the end of the year  … and the market may dive.

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Yesterday was day #1 of a highly likely – and predictable stock sell off.

Why a sell-off?

Well, some folks (i.e. me) expect a sharp market drop.

They’ll be selling —  if they haven’t already – to lock in  gains.

Why?

Because, it’s unlikely that President Obama will suddenly do a turnabout and become business-friendly.

So, despite perpetual quantitative easing, stocks are likely to be pressured.

Even if Obama does become pro-business, there’s the impact of the forthcoming capital gains tax bomb(s).

For openers, ObamaCare’s initial $1 trillion cost projections (which have already doubled) … were funded (on paper, that is) roughly half by cuts to Medicare and half by tax increases.

One of the tax increases is a 3.8% tax on investment income … essentially slapping payroll taxes on so-called “unearned income”.

“Unearned income” is defined as:

• short- and long-term capital gains
• dividends
• interest, except municipal-bond interest
• income from the sale of a principal home
• rents
• royalties
• the taxable portion of annuity payments
• a net gain from the sale of a second home
• passive income from real estate and investments, such as limited partnerships

So, at a minimum, capital gains tax rates will go from 15% to 18.8%.

In addition, Obama is on record pushing for a 5 point increase in the base capital gains tax rate to 20%.

• Note: Simpson-Bowles recommended a hike to the ordinary income tax rate.

Bottom line: the capital gains tax rate is likely to go from 15% to 23.8%.

One implication of increasing marginal tax rates is that investors have an incentive to sell appreciated stocks, bonds, and other assets before the end of the year … and pay the 15% rate instead of the jacked-up 23.8% rate.

As a result, tax revenues increase … when the capital gains taxes are incurred.

That is exactly what happened following the enactment of the Tax Reform Act of 1986, which increased the top capital gains tax rate from 20 percent to 28 percent.

Capital gains realizations almost doubled in 1986 and then fell back in 1987 as investors rushed to take advantage of the soon-to-expire 20 percent rate.

Similar behavior is likely this year unless investors believe that the threatened tax increases are merely head fakes.

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Practical implications

Note: I don’t provide investment advice, but I’m willing to share some research I’ve done …

Question: I like my stocks and want to keep holding them … what to do?

You can sell them, pay the 15% rate on capital gains and buy the same stock back … resetting the cost basis at the buy-back price.

Question: Isn’t that a “wash sale”?

Nope.

Wash sale rules only apply to stocks sold at a loss.

When you sell stocks at a loss, you have to wait 30 days to buy them (or comparable stocks) back.

But, if you sell at a gain, you can rebuy immediately … it’s not a wash sale.

Question: I’m only re-investing 85% of the proceeds since I have to pay 15% capital gains taxes, right?

Remember, you only pay capital gains taxes on, well, the capital gains … not all the proceeds.

Question: But, with the laws of compound interest, I lose a lot by reducing my principle even a little, right ?

Based on my back-of-the-envelop calculations, a stock has to go up at least 70% to offset the benefits of taking advantage of the lower capital gains tax rates.

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In summary

I’m expecting a stock sell-off in Q4 – partly from investors locking in gains and partly from folks arbitraging the capital gains tax rates – current and anticipated.

The most likely result: lower stock prices … but higher government tax revenues.

We’ll see ….

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This entry was posted on November 8, 2012 at 6:57 am and is filed under Taxes. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.