The recently released Senate tax reform bill contains a little-noticed provision that could have important consequences for stock and mutual fund investors if it becomes law. Though the bill has not been voted on by the full Senate, this provision could affect how capital gains or losses are recognized when securities are sold in taxable accounts.
Background
Investors often purchase shares in a security over a period of years. This typically happens when new money is added to the portfolio, dividends are reinvested, or from the periodic rebalancing of the portfolio. Since stock prices have historically risen over time, the most recent shares (or “tax lots”) are often acquired at higher prices than the earlier ones.
When purchases of single security have taken place at different prices, current rules allow individuals the flexibility to choose the order in which those purchases are sold. Since investors naturally want to defer taxes as long as possible, most people will sell their most expensive tax lots first. This can minimize or eliminate capital gains taxes and possibly create a tax loss, even though the position as a whole is profitable.
Example
Suppose you own 20 shares of Apple, half of which were bought in 2014 for $80 per share, and the other half in early 2017 for $175 per share. Today, the shares are trading at $170, so overall you’re ahead on the investment even though you’re down on the last share purchase.
If you sold 10 shares today for a price of $170, current rules allow you to designate the most expensive shares as the first ones sold. In this case, it's the shares you acquired for $175 which creates a tax loss of $5 per share. This is we handle it for our managed accounts.
Proposal
The Senate tax bill does away with this kind of choice. Instead, it would require individuals to sell the oldest shares first. Thus, when selling your 10 shares of Apple, you would sell the 2014 shares before the 2017 shares. This would create a $90 taxable gain per share instead of a $5 deductible loss.
Who Would This Affect?
The proposal only applies to investors with taxable accounts. It has no effect on retirement accounts and IRAs since those accounts don’t pay taxes on sales. It also has no effect when the entire position is sold at the same time since all of the tax lots are disposed together.
What Can You Do?
First, keep in mind that the full Senate hasn’t voted on the bill. Moreover, the House already passed their version of the tax bill, and it omits this provision. A lot can change to the tax legislation before it becomes law. The Senate bill may also fail to get the necessary votes to pass.
Still, if the provision becomes law, the effective date is expected to be January 1, 2018. This creates a planning opportunity because investors have through December to take advantage of the old rules.
Here Are Some Planning Opportunities If the Provision Becomes Law:
- Before doing anything, speak with your broker, financial advisor or us about the proposed law. For in-house investment clients, we will review all taxable accounts for planning opportunities as needed.
- Review your portfolio for unrealized gains. Your online brokerage account can break this down by individual tax lot. If some of the high-cost tax lots have a small gain, or even a loss, consider selling those lots before year-end.
- Pay attention to mutual fund dividends in December. These dividends are commonly reinvested in more shares which create new high-cost tax lots. These can often be liquidated before year-end at minimal tax cost.
With careful planning, the effects of the capital gains provision can be minimized if it becomes law.