A Change to Capital Gains

by Jay Pestrichelli on September 24th, 2012

In the weekend Wall Street Journal there was an opinion about the impact of a change to capital gains titled A Capital Gains Primer.  If you missed it, it essentially made the case that the long-term capital gains rate increase would be harmful for the economy.  It outlines the linkage of tax rates and capital investments, job creation, and the lack of accountability for inflation. The article is worth a read as we approaching the fiscal cliff. 

This accelerated our thinking about what the impact of the expiration of the Busch tax-cuts will have on the market. And while there are multiple impacts to consider, consider that the President is proposing raising the long-term capital gains tax from 15% to 23.8% for those making more than $250k and to 30% for those earning $1 million a year.  

Let’s take out the political aspect of this for a moment and concentrate on the hard reality of what goes through the mind of an investor. In our book Buy and Hedge, Immutable law #5: The Taxman Cometh, reminds us that what really matters is what you make AFTER taxes are paid. If an investor is going to pay fewer taxes on an investment selling before 2013, then there is going to be a bias to selling before 2013. Simple logic tells us that we should expect a higher than usual amount of selling activity at the end of the year.

There’s a naturally higher amount of selling in December already due to those looking to book losses to offset gains. This is normal behavior and we actual encourage it. With options we can keep the same position through synthetic positions and still take the tax losses. An example of a synthetic long stock position is buying a call and selling a put at the same time at the same strikes. By selling stock that you took a loss on during the year, and creating a synthetic position, you can avoid the wash sale rule and book the tax benefits.

However, we now throw into the mix that holders of large amounts of stocks may look to sell while they can get a lower tax rate on their long-term gains.  So now there are sellers with gains, and sellers with losses. I guess the only ones incented not to sell are investors that are flat. We believe this can cause downward pressure towards the last month of the year and can potentially stall the rally.

Let’s not forget that dividends are also going to fall into this higher tax rate. That can mean the pressure could be higher in those high-dividend stocks that have done so well this year.  We have heard rumors that in advance of this tax change possibility, some companies may do one-time large dividends to keep investors in their stocks longer and to take advantage one last time of the lower rate, so expect wild swings not usually seen in these equities.

Bottom line, you can just add this to the many reasons why the market will wait until after the election to decide which way it will move and finish the year. 

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