The United States elections will be taking place this November, capping off an event-filled year, to say the least. All 435 seats in the House of Representatives, 35 of the 100 seats in the Senate, and the office of President will be contested. Among several potential changes under a Biden/Democratic regime are modifications to the tax code.
Two of Biden’s proposed changes are an increase in capital gains tax for high-income filers and the elimination of stepped-up basis. In this blog post, we will examine the impact of each on taxable investments.
Currently, short-term capital gains are taxed at the ordinary income tax rate, while long-term gains are taxed at a lower rate. For the highest-income bracket, this is 20%. Also, the Net Investment Income Tax (NIIT) of 3.8% applies to individuals and couples earning more than $200,000 and $250,000, respectively.
Biden’s proposal calls for filers earning over $1,000,000 to pay ordinary income tax rates on their investment gains, regardless of the holding period. This would effectively raise the long-term capital gains tax rate to 43.4% (39.6% + 3.8%) for the highest earners.
Under this proposal, there would be no difference in tax rates between short-term and long-term gains for high-income filers. An optimal tax-loss harvesting strategy would shift from emphasizing long-term lots to emphasizing high-cost lots regardless of holding period.
The higher tax rate on capital gains would lower after-tax returns across the board. This would particularly harm actively managed strategies with high turnover due to frequent trading. Conversely, tax-optimized strategies would become more attractive. As tax rates increase, loss harvesting and gain deferral become more valuable.
For investors anticipating higher taxes, a tax-optimized portfolio manager could become more aggressive in harvesting losses and deferring gains. However, this may come at the cost of increased tracking error, according to Jeremy Milleson, a portfolio manager at Parametric Portfolio Associates.
A second proposal is the elimination of stepped-up cost basis upon death. Currently, an asset’s cost basis can be “stepped-up,” or adjusted higher, when it is passed onto an inheritor. For example, if an investor purchases shares at $20 and then passes them onto an heir when they are worth $100, the shares’ cost basis can be stepped-up to $100. When the inheritor eventually sells the shares, they will pay less realized gains tax due to the higher cost basis. This creates an incentive to hold onto appreciated shares rather than realizing gains. Removing stepped-up cost basis would take away this incentive.
Like the capital gains tax increase, this change would also reduce after-tax returns. Conversely, it would make donating securities more attractive, as there would be a higher incentive to gift appreciated securities. For charitably-inclined investors, it may make sense to systematically gift appreciated assets and replace them with cash, says Milleson.
The change would also result in greater flexibility in timing when to realize gains. Without an incentive to hold onto appreciated securities until death, gains could be harvested strategically over time based on an investor’s needs and other circumstances. One example of how to take advantage of this, according to Ben Schneider and Pete Hand, tax economists at Aperio Group, would be to time liquidations for when an individual’s income, and thus tax rate, is at its highest.
All of this comes with an important caveat. At this time, the details of how this change would get implemented are unclear. For example, we don’t yet know if unrealized gains would be taxable at death or if the original cost basis would be applied to heirs.
These are just some of the possible changes in tax law that may result from the upcoming election. Before taking any action, there are many other variables to consider. For example, even if Biden wins the presidency, the timing and extent of these changes may vary. Under a “clean sweep” scenario where the Democrats win control of the House, Senate, and White House, legislation may be more aggressive. However, even if these changes take place, they may be reversed by a future administration. Thus, there may be some value in holding onto appreciated assets in case stepped-up basis gets reinstated.
Our aim in this post is not to provide specific tax advice but to highlight the importance of working with a financial advisor and portfolio managers that are capable of navigating complex scenarios and optimizing under different circumstances. We recommend speaking to your advisor before the year ends to determine which actions, if any, you should take.
This article was written by Matthew Lui, CFA, CAIA, Vice President, Investment Research. As a member of Canterbury’s Research Group, Mr. Lui is responsible for sourcing, evaluating, and monitoring traditional, long-only equity managers. Mr. Lui serves as the chair of Canterbury's Global Equity Manager Research Committee and the vice chair of the Hedge Funds Committee. He also sits on the Capital Markets Committee. Prior to joining Canterbury, Mr. Lui was a trader and research analyst at Knightsbridge Asset Management. He received his Bachelor of Arts in economics from University of California, Berkeley. Mr. Lui is a CFA® charterholder and a Chartered Alternative Investment Analyst.