When is the best time to go cherry picking?

Q: Ed asks, “This year my accounts have grown substantially. Should I harvest my gains now or later?

A: Ed, that is a wise question. Gain harvesting is a great year-end strategy that could potentially save you substantial amounts of capital gains tax. The strategy applies to you if expect to be in a higher tax bracket in the future than in the current year. If this is the case, you will sell the assets this year, pay tax on the gains at the lower current tax rate, and step-up the basis of the assets to the sale price.

Then you will immediately repurchase the assets and sell them whenever you would have sold them if the gain harvesting strategy had not been used. By doing so, you shift recognition of part of the capital gain from the higher bracket future tax year to the lower bracket current tax year. The first consideration of many in deciding whether to use this strategy is determining what your expected tax brackets are over the coming years.

It may be advantageous for those in a lower tax bracket to harvest gains in the current year if they expect to fall into a higher tax bracket in later years.

Seems simple enough, but it’s not. The difficulty in deciding on whether or not to harvest gains comes when you were not planning on selling the asset for two, three, or more years. It becomes a battle between two competing benefits: paying tax at a reduced rate and loss of tax deferral. The best way to analyze these competing benefits is to think about gain harvesting as an investment in the current year to buy tax savings in a later year. This allows for a calculation of the rate of return on this investment.

Usually, if the taxpayers originally planned on selling the assets in the following year and they are in a lower tax bracket this year than they will be in next year, gain harvesting can be very beneficial. If the planned sale was farther in the future, however, loss harvesting may or may not be beneficial. The key variables to consider in deciding whether to harvest gains are: 1) The time period between the gain harvesting sale and the sale of the repurchased assets (i.e., the period of time between the sale in the current year and the sale in the originally planned year); 2) The difference in the taxpayer’s tax rates between the two sales; 3) The growth rate of the stock; and 4) The taxpayer’s opportunity cost of capital. As stated above, the shorter the time period between the gain harvesting sale and the originally planned sale, the more favorable gain harvesting will be. The decision of whether to harvest gains will be based on the taxpayer’s return on investment compared with his or her opportunity cost of capital (the return he or she could have earned on the best alternative investment of comparable risk).

Another important variable is the difference in tax rates for the two stock sales—the greater the differential in tax rates, the more favorable gain harvesting will be.

Miser Wealth Partners, LLC, has developed a Gain Harvesting Return on Investment calculator that allows us to quickly see what the return on investment of gain harvesting will be depending on the combination of the various variables mentioned above:

  1. The time period between the gain harvesting and the subsequent sale;
  2. The tax rate in the current year versus the tax rate in the year the asset will be sold;
  3. The asset’s growth rate; and
  4. Any state tax rate.

Most importantly, if the taxpayer is currently in the 0% capital gains tax bracket, gain harvesting will always be favorable because it gives the taxpayer a free basis step-up. Thus, always make sure to fill up the 0% capital gains tax bracket. Furthermore, if the taxpayer is nearing death and plans on keeping the asset until death to pass it on to his or her heirs, then there is no reason to harvest gains now because the taxpayer (or his heirs) will get a free stepped-up basis at the time of the taxpayer’s death. Lastly, before engaging in gain harvesting, be sure to take a look at the economic substance doctrine. IRC § 6662(b)(6) imposes a 20% penalty on any underpayment of tax due to a transaction that lacks economic substance. That penalty increases to 40% if the transaction is not adequately disclosed on the return. IRC § 7701(o) provides that a transaction has economic substance only if: (1) it changes the taxpayer’s economic position in a meaningful way; and (2) the taxpayer has a substantial non-tax reason for entering into the transaction.8 From an investment perspective, the taxpayer would like to repurchase the asset as soon as possible after the gain harvesting sale to minimize the risk of the price increasing between the time of sale and the time of repurchase. When harvesting gains, it is difficult to see how either requirement above would be met if the sale and repurchase occurred on the same day or perhaps within a very short time period. If the time between the sale and repurchase is very short the IRS might take the position that the sale lacks substance. The seller has claimed a basis increase without really cashing out his or her investment or changing his or her economic position. However, gain harvesting would present a rather unusual situation for applying the economic substance doctrine. This is because there would be no understatement in the year the gain was harvested and you could not speculate in the current year how much might be saved later.

Nevertheless, if the investor’s tax rate was higher when the repurchased asset was later sold, the IRS might take the position that the penalty applied in the year of the second sale.

Example 3. Ken and Julie, married taxpayers filing jointly, own X Corporation stock with a basis of $10,000 and a fair market value of $40,000. In Year 1, when their other income is $43,800, they sell the stock, recognizing a gain of $30,000 and immediately repurchase the same stock. Because their total income for the year is less than $80,000, they are in the 0% capital gain bracket and they obtain a basis step-up without paying any capital gains tax. In Year 3, Ken and Julie’s income has increased to $100,000 and the value of the X Corporation stock has increased to $50,000. They sell the stock, recognize a gain of $10,000 and pay capital gains tax of $1,500 (.15 x $10,000). It is not clear whether the IRS could (1) take the position that the Year 1 sale lacked substance, (2) deny the $30,000 basis increase, (3) claim an underpayment of $4,500 in Year 3 (.15 x $30,000), and (4) impose penalties on the understatement under IRC §§ 6662(b)(6) and 7701(o).

To be safe, taxpayers who harvest gains might wish to build substance into their sales. One way to do this would be to lengthen the time between the gain harvesting sale and the repurchase. For tax purposes, the longer the delay, the more likely it would be that the transaction would be treated as having economic substance because the taxpayer is subject to market risk during the intervening period. A longer time period would also make it easier for a taxpayer to show a nontax motivation for the sale. If it turns out that the economic substance doctrine applies, taxpayers will want to make the delay as short as possible without taking a significant risk that IRC § 7701(o)(1) will apply. How long this period is will depend on all the facts and circumstances of the case and is difficult to determine. Another way to build substance into the transaction would be to repurchase assets that are similar, but not identical to the assets harvested.

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