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Taxes!

I bring up the unpleasant topic of taxes in the spirit that a little proactive pain today can prevent larger pains later. Bear with me.

First, the capital gains situation.

This year’s capital gains situation was summarized in our March 31, 2020 Investment Commentary:

Taxable investors saw a high tax bill for 2018 as we sold a number of longer‐term holdings with large capital gains accumulated since the financial crisis. Big capital gains years like that are few and far between, and we thought it might be quite some time before we saw something similar. The coronavirus has proven us wrong, and the 2020 tax year might look a lot like 2018 for many taxable portfolios.

We do not like paying taxes, either. Selling winners is not done lightly; we must weigh the benefits of selling, which can’t be calculated exactly, with the cost of selling, which is known. Often, selling is a mistake in hindsight. Nonetheless, it’s a critical component toward our primary objective of preserving assets and maintaining liquidity.

Since the first quarter, we have taken more long-term capital gains. Clients with taxable portfolios will likely see a relatively large total capital gain figure in their 2020 tax reports.

In at least a few client meetings and calls where my extreme sense of guilt moved me to deeply apologize over taxes, clients have pointed to the bright side: “Taxes mean we made money!” That clients would console their advisor over their tax hit is but another indicator that we have the greatest clients anywhere.

I still agonize over taxes. I’ll help myself here by offering another silver lining to the situation: Tax rates have a good chance of increasing in 2021. This may be an understatement if the forecasts from polls and betting markets prove right, and Democrats control the House, Senate, and the White House after the election.

In Joe Biden, Democrats nominated a relatively moderate choice as opposed to a more progressive (or self-identified democratic socialist) one. While Biden’s tax plan is not as aggressive as those of Elizabeth Warren or Bernie Sanders, it still calls for material increases in certain tax rates compared to prevailing rates today.

The Biden tax plan would enact policies that would raise taxes, including individual income and corporate taxes. Some highlights:

Higher Tax Rates in 2021?

  • Raise individual income taxes for those with income above $400,000 from 37% currently to pre-2017 levels of 39.6%. The current top bracket of 37% starts the $518,000 income level (for individual filers).
  • Impose the 12.4% Social Security payroll tax for wages above $400,000.
  • Tax long-term capital gains and qualified dividends at the ordinary income tax rate of 39.6% on income above $1,000,000.
  • Eliminate step-up in basis for capital gains taxation and allow the scheduled reversion in estate tax exemption to $5 million per individual in 2025 (the per-person exemption is $11.58 million in 2020).
  • Cap the tax benefit of itemized deductions and limit deductions for higher earners.
  • Phase out the qualified business income deduction (Section 199A) for incomes above $400,000.
  • Increase the corporate income tax rate from 21% to 28%.
  • Create a minimum corporate tax (an alternative minimum tax) for corporations with book profits of $100 million or higher.

The biggest change on the margin for high net worth individuals could be the change in capital gains taxes. Today’s maximum tax rate of 20% increasing to 39.6% (both rates are stated before the Obamacare tax surcharge) would represent a near-doubling in capital gains taxes for certain individuals, including many of our clients.

This prompts a question: Are high earning/wealthy clients better off if they take even more long-term capital gains in 2020? This and other possible tax changes are worth discussing now with your CPA before the November election and before CPAs (and tax and estate planning attorneys) face a deluge of client requests.

Another big change intersects capital gains and estate planning. Currently, cost basis is “stepped up” upon one’s death, and heirs are freed of capital gain tax liability. Biden’s plans would eliminate the step-up feature. This is huge. Many appreciated assets in real estate, stocks, private businesses, etc. are not sold by seniors because the capital gains can be both deferred and eventually eliminated at death. We see a lot of this in the course of business and realize it is a consideration in the course of financial planning.

From a market perspective, the implications of all these tax changes could be increased selling to capture today’s low capital gains rates. And the selling could start early as investors look to sell before others sell. Conversely, delaying losses for 2021 might capture more deduction value, all things equal. This speculation alone will not drive investment strategy, but it is something to watch especially given a backdrop in elevated prices in stocks, bonds, real estate, venture capital—you name it.

I am no tax professional, and none of this is actual tax advice or strategy ideas. The only advice I offer is to contact your tax professional and possibly your estate attorney. The sooner the better so you can be equipped with what to do—having a Plan A, Plan B, etc.—based on what happens in November. Markets could move fast. Waiting until late December for tax selling or strategy is not ideal, to say the least, and it could be risky. Remember, your CPA and attorney could be extremely busy starting early November, if not earlier.

State and Local Tax Changes

In recent years, we have noticed more aggressive rules and tactics regarding taxation from states and even municipalities. In short, between increasing tax rates, introducing new taxes, and broadening definitions of tax “nexus” (allowing states to tax more people and activities inside and outside their state’s borders)—taxes and tax complexity seem to be only rising. For example, some people today are finding their work or income subject to taxation in two states. Newer accords among certain states have streamlined some issues, but any progress seems little compared to all the enacted measures across the U.S.

States continue to focus on revenue enhancements as politics makes it difficult to change or even address spending problems or inefficiencies. Finances continue to deteriorate everywhere[1]. California, often a leader in matters of law and regulations (both good and bad) may enact the nation’s first state wealth tax.  

As most readers of this note will probably be skeptical at best about any new tax or tax increase coming from California especially, here is a take-down of the proposal.

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[1] A study from Eaton Vance cited in Barron’s (8/31/20) listed states based on creditworthiness with inputs from (1) debt and unfunded liabilities as % of GDP; (2) jobless rate; (3) rainy day funds as a % of revenue; (4) FY20/FY21 revenue shortfall estimate; (5) Moody’s/S&P credit rating; and (6) bond yield spread over a AAA benchmark.

The Bottom 10 in Creditworthiness, in reverse order:

50. Illinois

49. New Jersey

48. Kentucky

47. Pennsylvania

46. Rhode Island

45. Connecticut

44. Louisiana

43. West Virginia

42. Mississippi

41. Kansas

40. Hawaii

About the Author


Neil Rose, CFA
President & Chief Investment Officer
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