In my book, Buy and Hold is Dead (AGAIN), the Case for Active Management in Dangerous Markets, I devote an entire chapter to portfolio tax planning. The tax chapter is called, The Tax Tail and the Portfolio Dog. The title refers to an old saying about taxes that basically means that investors shouldn’t let tax considerations outweigh value considerations when making asset allocation decisions. The chapter borrows heavily from the work of Michael Kitces, Director of Research at Pinnacle Advisory Group, who points out that unless you die with appreciated securities in a taxable portfolio and get the currently allowed step up in tax basis, the value of most tax strategies is limited to the value of tax deferral. The chapter goes into great detail to show that the value of tax deferral is not as great as most people think it is, and the resulting conclusion for value investors is simple…don’t let tax considerations keep you from selling overvalued assets.
It is possible that this year will put many investors to the test regarding realizing capital gains in actively managed portfolios. The speed and magnitude of the current stock market rally is such that investors will be forced to look at the value proposition of holdings that may have doubled in value since March of this year. If by year-end investors conclude that holdings are overvalued, and if they were purchased within the past 12 months, then they will have to weigh the tax cost of short-term capital gains versus the risk of holding securities for the full 12 month period needed to get the more favorable long-term capital gains tax rate. For savvy investors who bought the market after the severe post-Lehman Brothers market decline in September, they will be “playing chicken” with the markets as they approach their 12 month holding period. Investors with the best market timing will have to hold until next March to get to the favorable long-term rate.
For the record, if you own a security with a 20% gain it only has to retrace 3.06% of its value to completely wipe out the benefits of short-term versus long-term capital gains (assuming 28% short-term gain rates and 15% long-term rates). For 50% gains the breakeven pullback is 7.65% and for 100% gains the breakeven is only 15.29%. Students of market volatility would conclude that the potential for losses from overvalued levels should lead investors who want to protect their profits to go ahead and take them without worrying too much about tax costs in the transaction. Of course, investors may have large amounts of loss carryforwards, or unrealized losses that can be realized in their portfolios in order to offset gains this year. It will be interesting to observe investor tax behavior as we approach the end of the year.
