The House and Senate tax bills are about to go to conference committee for negotiation. The Senate tax bill changes the capital gains tax calculation.
If you own investments in stocks, ETFs, or mutual funds, I want you to know how about this change. I also want to encourage you to review your finances before year-end to see if you need to take action.
Capital gains under current law
Under current law, investors who sell shares of stocks, ETFs or mutual funds get to choose which shares to sell. Selecting shares allows you to control your capital gains.
Let's say you own 1000 shares of XYZ stock. You purchased your securities over the years at a cost ranging from $10/share to $70/share. The stock is currently selling for $100/share. You need $10,000 in cash and decide to sell shares of XYZ to raise the money. To minimize taxes on your sale, you decide to sell the 100 shares purchased at $70/share. Doing that results in a capital gain of $3,000. Selling the shares, you paid $10 for results in a capital gain of $90/share or $9,000. That's $6,000 more than the $70/share stock.
If you own mutual funds, an additional option you have is to use an average cost per share when selling. The result of this is to smooth out the share price when selling. Using the above example, let’s say your average cost per share is $50. Selling with the average cost method, your capital gain from selling that 100 shares would be $5,000. That's still a significant saving ($4,000) from selling the $10 shares.
Capital gains under the Senate tax proposal
Regardless of the vehicle chosen (stocks, mutual funds, ETFs), you invested in stocks with the expectation that the price would go up, right? Perhaps dividends were part of the reason for choosing some of those investments. However, you expect the value of those investments to go up over time. With favorable capital gains tax rates, selling those shares held longer than one-year provides reduced tax rates (15% or 20%) for most people. The ability to choose which stocks get sold offered great flexibility to control how much tax you paid on selling.
If the Senate bill becomes law, all of those options go away. Their proposal requires that you sell the oldest shares first. In accounting terms, that's called the first-in-first-out (FIFO) method. Under the FIFO provision, the first shares purchased often represent the lowest priced stocks. In the above example, the 100 shares sold would be the ones you bought for $10. You would lose the choice of selling the $70 shares. So, your capital gain would be $9,000. Once the $10 shares are gone, you would sell the next oldest shares. That process would continue until all shares get sold.
What you should do now
If you own stocks in any form, get with your financial advisor, tax accountant, or custodian and review the cost basis of all those securities. Cost basis means merely the price you paid for your shares.
Take advantage of tax-loss harvesting opportunities before year-end. Tax loss harvesting means selling investments whose value is below what you paid for it. If you have investments whose current value is below what you paid for them, consider selling them before 12/31/2017. Doing this allows you to lock in that loss. If this provision of the Senate bill becomes law, you will lose the ability to choose which securities to sell.
Let's say you paid $100 for 100 shares of stock that currently sells for $50 per share (that would be a bummer, huh?). You would have a $50 per share loss if you sold at that price. Selling that stock now locks in that $5,000 loss, which can be used to offset any sales made during the year at a profit (long-term gains against long-term losses, short-term against short-term). Unused losses can be carried forward and used in future years. So, even if you don't have capital gains this year, these losses won't go to waste.
None of us know what the final outcome of the tax reform proposals will be. However, in light of the potential FIFO treatment of capital gains, it makes sense to review your investments before year-end. Locking in tax losses by selling investments you own at prices below what you paid puts you in control of those taxes. If this provision becomes law, you lose that control.
There is still time to act.Talk to your accountant or financial advisor if you need help. If you manage your own investments, check with your custodian or mutual fund company to get the information you need. Whatever you do, don't wait for the final outcome. If you do, it may be too late.
What do you think? Will this provision become law? Will it impact your situation? Post your comments below.
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