Don't Listen To The So-Called Experts: Don't Harvest Gains!
Let’s outline the basic reasons why harvesting gains doesn’t make sense.
1) Clients don’t like to pay taxes.
2) There’s no guarantee that capital gains rates are really going up
next year.
3) Deferral techniques can avoid or postpone capital gains taxes.
4) Clients might have capital loss carryforwards.
5) Clients might use appreciated securities for charitable donations.
6) Investments owned at death receive a step up in basis.
Clients don’t like to pay taxes. Our whole game is tax deferral and tax avoidance. That’s why we generally harvest losses, choose high cost lots and consider location optimization. When clients see their tax bills on April 15th, they are not happy if they need to pony up money because their investments threw off taxable income. Even if it sounds short-sighted, the “bird in the hand” matters most to clients. Trying to convince them to pay taxes now goes against every instinct they have – and many of them believe that their personal tax rates will decline over time.
There’s no guarantee that capital gains rates are really going up next year. I agree that it will be difficult for Congress to stop the moving train. Yet, there’s always a chance that they will postpone or eliminate the increase. How will clients react to accelerating gains if there is no change to capital gains rates? Although you could wait until the last minute to recognize gains, the logistics and potential market volatility could work against you.
Deferral techniques can avoid or postpone capital gains taxes. Choosing high cost lots, harvesting losses along the way and generally adhering to a “buy and hold” strategy, can postpone tax recognition for many years. In fact, it might be possible to defer a good chunk of accumulated appreciation until clients pass away. Postponing long enough could pass the “time value of money” break-even point. And, paying tax now on 100% of appreciation versus paying tax later on less than 100% of appreciation would not be beneficial.
Clients might have capital loss carryforwards. Recognizing gains that will be offset by capital loss carryforwards will only serve to reduce future tax benefits. The capital loss carryforwards will eventually offset higher-taxed capital gains if not utilized in 2012. Thus, continuing to harvest losses can be a great strategy for your clients.
Clients might use appreciated securities for charitable donations. Clients that regularly contribute to charitable causes can use appreciated securities, thereby avoiding gain recognition altogether. There would be no point in accelerating gain recognition in this case.
Investments owned at death receive a step up in basis. Death avoids capital gains taxes on appreciation. Assuming that clients are not going to liquidate all holdings during their lifetimes, postponing gain recognition as long as possible can lead to full tax avoidance.
Is there ever a reason to accelerate capital gains taxes? Yes. In particular situations, it might make sense to recognize capital gains in 2012. First, you’d want to be sure that tax rates are truly increasing in 2013. Then, you need to analyze based on the client’s unique circumstances. For example, your client is selling a business on an installment sale basis. Electing out of installment sale treatment could save significant tax dollars.
The bottom line: Harvesting gains will likely only benefit a small minority of your clients.