Since US President Joe Biden unveiled his proposal for a broad tax overhaul, investors have been asking whether it makes sense to recognize investment gains before a potential rise in the capital gains tax. The answer? We think it depends on three key variables: expected future tax rate, expected returns, and investment horizon.
Let’s start with a look at the current tax policy and what might change. Investment gains on equity positions owned for more than one year are known as long-term capital gains (LTCG), and these are currently taxed at a rate that’s significantly lower than the rate applied to positions held less than one year, which are known as short-term capital gains (STCG). Under the proposed tax policy changes, tax rates on LTCG and Qualified Dividend Income (QDI), which also receives preferential tax treatment, would nearly double for investors in the highest income bracket, bringing them in line with the current STCG rate (Exhibit 1).
In addition to changes in the LTCG and QDI tax rates, the president’s plan includes changes to the tax treatment of assets transferred at death. As it stands now, the tax code “steps up” a portfolio’s cost basis to current market value when assets are transferred upon death and does not tax the unrealized gains. In the Biden plan, taxes on unrealized gains in a portfolio would be owed when the owner dies.
The combination of a higher LTCG tax rate and the removal of the “step up in basis” provision suggests it may potentially benefit investors to take action now to reduce the tax impact of portfolio liquidation or death. Still, it’s important to remember that tax rates are variable and can change when presidential administrations change. That’s why the primary consideration for this gain recognition exercise is to determine in which scenarios it is most beneficial to realize gains and pay taxes now instead of deferring until later.
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