There’s apparently plan floating around Washington that would dramatically change capital gains taxes, in my opinion, for the better.
I try to be impartial about political matters (not always successfully, according to some readers), so for now, I want to leave aside the debates about whether the plan only benefits the rich, inappropriately adds to the deficit or whether it should be an act of Congress or a rule change at the Treasury.
I don’t have answers or opinions for those questions, so it’s pointless for me to address them anyway.
If you haven’t heard of the plan, the idea is fairly simple: adjust the cost basis of an investment to inflation, which will reduce the capital gain, and therefore, the tax on the capital gain.
Let’s look at an example. Imagine that you invested $10,000 in a stock 10-years ago. That $10,000 is the cost basis. Let’s now assume that the stock earned 10 percent per year over that time and is now worth about $25,900 (I’m rounding, for simplicity).
Your investment was a winner, and you have a capital gain of $15,900, which will likely be taxed by the Feds at 15 or 20 percent (it could be zero, but let’s leave that aside too). At 20 percent (forgetting the Medicare surcharge) tax rate, the taxes due would be $3,180.
That’s how things stand today; but let’s now consider what would happen if the Trump administration is able to change things.
Let’s add a new hypothetical to our scenario, which is that inflation was also 10 percent. I know, it’s almost impossible to imagine that given how low inflation has been over the last decade, but I think this will illustrate the point.
If inflation was that high, the cost basis would have adjusted each year and ended up at $25,900, which would mean that – adjusted for inflation – there was no capital gain and, therefore, no capital gains tax.
The reason that I think this is fair (again, forgetting the aforementioned debates) is the idea that the original $10,000 can only buy $10,000 worth of goods and services 10-years later thanks to inflation.
In fact, if you have to pay $3,180 in taxes, you can’t buy as many goods and services today as you could 10-years ago. My quick calculation suggests that, after-tax, the original investment is now only worth $8,800 (again, rounding).
I don’t think that this is a fair outcome. I’d never heard of indexing cost basis by inflation, but I immediately liked it from an investment standpoint. Not only do I think it’s fairer, but it would reduce the number of tax-driven decisions that we and our clients have to make.
You may remember the story that I wrote in April about my wife and I inheriting some General Electric stock (if you don’t remember, you can read it here). My wife received the gift while her grandfather was alive, which meant that her cost basis dated back to the 1940s.
I sold the stock because we had too much of it, but I know that other family members didn’t because they didn’t want to pay the capital gains tax. I can understand that argument, and in this case, I got a little lucky and sold out long before the problems at GE surfaced.
If the cost basis were indexed to inflation, then the tax bite would have been a lot smaller. Maybe some of my family members would have been more open to doing what they think is best with their money, instead of trying to avoid taxes.
Surely, this kind of change would make things more complicated, and I, like everyone, want the tax code to be less complicated. I’ve also read articles saying that indexing the cost basis without indexing other taxable income would create a lot of tax shelter opportunities. That may be true, I don’t know.
Conceptually, I like the broad idea, in theory and in practice. That said, I have my doubts about whether the idea will make its way into the real world, but who knows? Sadly, not me.