At Sigma, we traditionally use the end of the year to go through taxable portfolios and sell positions that have significant losses so that they can be used to offset realized gains for our clients. This simple process is used to lower tax bills through a few straightforward trades and is a no-brainer if tax rates are expected to remain the same or decrease in the future.
Up until recently, 2010 was quite unique as it pertained to tax planning because there was a possibility that tax rates were going to increase materially in 2011. The Bush tax cuts were previously set to expire on January 1, 2011, which would have introduced a host of tax ramifications. The top tax bracket for ordinary income rates was set to increase from 35% to 39.6%, long-term capital gains rates were set to increase from 15% to 20%, and the estate tax exemption was set to revert to $1 million per individual with a 55% tax rate to be applied to any amount above the exemption.
As it turns out, the Bush tax cuts were extended for an additional 2 years by way of a last-second piece of legislation out of Washington. Had this not happened, Sigma was prepared to depart from the traditional process of harvesting losses.
For example, suppose a taxable portfolio has long-term realized gains of $10,000 in 2010. This would amount to a $1,500 tax liability at the current long-term capital gains tax rate of 15%. Also, suppose that the same portfolio has $10,000 of unrealized losses that could potentially be harvested by selling the securities with the losses. That $10,000 of losses would then result in a tax asset of $1,500, thus completely offsetting the aforementioned taxable gain. However, if Congress had let the long-term capital gains rate revert back to 20% in 2011 this would not be the ideal strategy. One could have theoretically paid their $1,500 tax liability in 2010 and not harvested their $10,000 loss until January 2011. This would have resulted in a tax asset of $2,000 for 2011 because of the new higher capital gains tax rate. By not harvesting losses in 2010, this person would have gained an additional $500 in tax assets. In essence, the above unrealized losses would be more valuable if used against future gains in a higher tax rate environment, as opposed to offsetting current gains in 2010.
While tax rates are not going up (for now), and the above example of deferring losses will not be implemented broadly across our client base, this at least gives one a sense of the thought process that underlies some of our tax planning for clients. This also sheds some light on the scenarios that must be continually mulled over because of the current complexity of the US tax system.
A change in tax rates would have portended many things, one of which would have been a change in mindset as we approached year-end tax planning for clients. With the recent tax legislation having been passed and tax rates remaining unchanged in 2011, the process of year end tax-loss harvesting is business as usual.
Christopher W. Frayne