Unless Washington acts in the lame-duck session after the November elections, top rates for capital gains from most sales of assets owned more than 12 months are scheduled to increase. They will go from 15 percent for 2012 to at least 20 percent for 2013.
If it appears that the tax hikes actually will take effect, stocks could decline as investors unload shares to lock in lower current rates. But regardless of whether there are increases, long-term gains will continue to be taxed more favorably than short-term gains from sales of assets owned less than 12 months.
With all these uncertainties, should savvy investors opt to realize short-term gains from sales of assets owned less than 12 months, so as to nail down profits, albeit causing them to be nicked for taxes at the same rates (as high as 35 percent for 2012) as ordinary income from sources like salaries and pensions? Or is the wiser strategy to stand pat until those profits become long-term, meanwhile hazarding declining prices that more than offset the lower taxes?
To illustrate the alternatives, assume that Norma Bates' regular income-tax bracket is at least 25 percent -- for 2012, taxable income above $35,350 for singles and $70,700 for joint filers. Norma has a sizable unrealized gain on shares of Beefsteak Uranium, a volatile stock she has owned for fewer than 12 months. She's considering selling her BU shares for fear of plummeting prices caused by terrorist attacks or world instability. Her worst fear: photos of BU's top execs being booked on charges of securities fraud and larceny -- for instance, cooking the books, spending company funds on personal indulgences (like the infamous $6,000 shower curtain for the home of L. Dennis Kozlowski, the fired and convicted chief of Tyco International Ltd.), or other kinds of corporate chicanery.
Without getting into the issues of price volatility and potential market shocks, Norma has two options for that kind of short-term paper profit. The first option is to unload the shares now and secure the short-term gain, but suffer the loss of at least 25 percent and as much as 35 percent of the gain to the IRS. Plus, depending on where she lives, she may also owe state and/or city taxes on this money. The other option is to hold off on a sale until the gain becomes long-term, and forfeit no more than 15 percent of it to the IRS, plus local levies. The drawback, as noted, is a price drop that exceeds the taxes saved.
How much of a drop can Norma endure while waiting until she qualifies for the lower rate and still be no worse off after taxes? For the answer, she uses the following three-step formula: First, figure her after-tax return on the short-term gain. Second, divide this amount by her after-tax return on the same amount of long-term gain. Third, multiply the short-term gain by the resulting percentage. The result shows how much the price can drop, yet permit Norma to keep as much after taxes from a smaller long-term gain as she would from a larger short-term gain.
To make the math less formidable, suppose Norma's paper profit is $10,000. Her combined federal and state brackets for gains is 30 percent for short-term and 20 percent for long-term. A $10,000 gain (after any sales expense) taxed at 30 percent entitles the tax collectors to $3,000 and leaves Norma with $7,000. The same $10,000 taxed at 20 percent leaves her with $8,000. Divide $7,000 by $8,000; the resulting percentage is .875. Multiply $10,000 by .875 and the result is $8,750. A smaller long-term profit of $8,750 taxed at 20 percent leaves Norma with $7,000, as much as would be received were she to sell for a $10,000 gain and be taxed at 30 percent.
Given those numbers, when does a decision to sweat out the 12-month holding period leave Norma worse off after taxes? Not until her paper profit drops from its present $10,000 to below $8,750--that is, by more than $1,250.
Julian Block is an attorney and author based in Larchmont, N.Y. This article is excerpted from "Julian Block's Year Round Tax Savings," available at julianblocktaxexpert.com.