Tax Plan Time Bomb Creates Huge Now-Or-Never Planning Opportunity

Senate version incentivizes selective loss harvesting now and duplication of investment accounts in the hereafter, provided of course it passes.

The capital gains system almost made it through the biggest tax negotiation in a generation unscathed. If reconciliation goes the right way, it may not ultimately change at all.

But until we know for sure, it’s all hands on deck. Investors with substantial unrealized gains need to use the freedom they have, while they have it.

The Senate wants to accelerate the rate at which they can tax those gains. It’s tax planning 101: when it looks like a loophole is closing, be ready to grab on short notice. 

And in a world where stock prices are at record levels and the IRS will tax your oldest shares first, odds are good a lot of your clients will want to buy a little flexibility before the new rules take over.

Tax lots at risk

Buried in the Senate version of the tax bill is a proposal to tax asset sales on a first in / first out basis. The freedom to pick a lot would go away. Instead, whenever an investor sells any shares of a given security, the oldest ones automatically go first.

That means that there’d be no flexibility in terms of whether to sell low-basis shares and take a big tax hit now on a big gain, or else play closer to breakeven in order to balance incremental gains here and there against outside tax considerations.

In theory, it’s only worth $2.4 billion to the IRS over the next decade, which is practically a rounding error in the overall tax package. But for people who have been saving highly appreciated shares for estate planning or charitable purposes, it’s a headache.

Remember, part of the joy of passing on stock to the next generation is that the basis steps up. If you’ve been sitting on shares that have made a whole lot of money, you’re not going to like being forced to liquidate those particular shares in the here and now.

And when advisors add value by mapping the order in which retirees cash out in order to pay the bills, the brute FIFO system has the potential to wreck decades of careful discipline.

Some tax gurus suggest that the new regime would shift the spotlight to more sophisticated loss harvesting as advisors find losing trades to balance against seasoned gains. 

I’m not convinced yet. Most of the work of conventional tax harvesting boils down to whittling down short-term gains taxed as ordinary income. 

With the longest-term trades automatically realized first, losses and gains simply occur at the long end — while there are scenarios where you’d deliberately engineer a short-term loss in order to offset the FIFO gain, I don’t really see them contributing to market stability.

As it is, I’m hearing a lot of retail accounts selling selectively now in order to get ahead of the new rules. That’s probably a drag on the market in a season when tax loss selling is routinely heavy.

If it starts feeding on itself, we could be in for a little holiday volatility before people buy back in and the January Effect takes over. After all, those lots would reset the clock at zero, so they’re not going anywhere until the entire portfolio turns over.

Trust and other accounts

Of course the gurus are already creating ways around the Senate’s system. First of all, moving the assets into a trust now pushes the ultimate tax impact away from the individual investor. 

Assign the oldest and most heavily appreciated lots to the trust while you can and the personal account comes away with only the relatively fresh assets — split the portfolios smart, and the personal account could even end up with unrealized losses to apply when it’s time to cash out.

For retirees with estate planning or philanthropic considerations, it’s probably a good idea to get the low-basis lots into the trust where distributions can be delayed as long as it takes to overcome the IRS drag.

Otherwise, the best idea I’ve heard so far involves shuffling the lots among multiple brokerage accounts. Supposedly the IRS is going to run the FIFO algorithm on an account-by-account basis, so splitting lots and then choosing which account to sell from restores flexibility.

It isn’t exactly elegant, but modern account aggregation systems make the process of tracking a household’s wealth across accounts fairly trivial. Pick the lot, find the account that holds it, carry on as normal.

Either way, it isn’t a bad idea to be ahead of the curve. Moving assets from account to account doesn’t count as a sale, so unrealized gains remain unrealized. And depending on Congress, we may only have a week or two to move the money around. 

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