Tax Puzzle

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Tortoise
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Tax Puzzle

Post by Tortoise » Sat Oct 21, 2017 2:10 pm

Assume you bought two securities in a taxable account earlier this year, intending to hold them for at least a few years before selling. One has appreciated by 10%, and the other has declined by 10%.

However, it now appears you’ll need to sell some of one or both securities to raise cash in the next week.

A relative has promised to send cash to completely reimburse you, but must wait to do so until January 1st for tax purposes (so that he won’t have to pay gift tax on it). You plan to use that cash to buy back whatever securities you sold a couple of months prior.

Given that you must realize either a loss or a short-term capital gain, what would be your strategy — sell shares of the appreciated asset and pay the taxes on them, sell shares of the depreciated asset and claim the loss on your taxes, or a mix of both so that the gains exactly offset the losses? And what would be your rationale?
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Re: Tax Puzzle

Post by Pet Hog » Sat Oct 21, 2017 5:27 pm

My rationale would be: don't lose money! So at least tax neutral.

If you began with $100,000 in each investment, now one is $110,000 and the other is $90,000 (ratio of 11:9), then you could sell an equal percentage of each to offset the capital gain. If, say, your loan amount is $20,000, then you could sell 10% of each: $11,000 and $9000, respectively. The first contains a $1000 capital gain ($10,000 + $1000) and the second a $1000 capital loss ($10,000 - $1000). Now your investments would be $99,000 and $81,000 -- still the same ratio (11:9), so not a rebalance! When the loan is paid back, you can add almost all of it to the lagging asset and return to two $100,000 investments again. This way you sell more of the winning asset, buy more of the losing asset, rebalance, and pay no tax. Something like that.
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Re: Tax Puzzle

Post by WiseOne » Sun Oct 22, 2017 9:33 am

Weird situation, Tortoise! I'd exhaust other possibilities of raising funds first, like selling CDs and mining the emergency fund. I guess that's already been done, but you might think about creatively using credit cards given the short time frame - if the money is needed for something that can be paid by credit card with no fees. A person with a decent credit rating should have no trouble getting a card offering 0% interest for 6-12 months and free balance transfers from existing cards. Then just make minimum payments until the loan/gift from the relative comes through.

If selling the appreciated asset means you get taxed at ordinary income levels, then I absolutely would sell the depreciated asset and enjoy the capital loss. As Pet Hog suggests, though, that may cause an issue with balancing if these are part of a balanced portfolio. I still would prefer that to paying ordinary tax rates on a gain though.
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Re: Tax Puzzle

Post by Xan » Sun Oct 22, 2017 3:10 pm

Does "completely reimburse" mean that he's paying the tax for you too? If so, then I'd sell the winner and realize the tax now. That's the only way to even know what the final tax bill will be for the event until who-knows-when.
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Re: Tax Puzzle

Post by Libertarian666 » Sun Oct 22, 2017 6:11 pm

I agree with the suggestion to sell enough of the winner and enough of the loser to cancel out the tax liability.
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Re: Tax Puzzle

Post by mathjak107 » Mon Oct 23, 2017 7:27 am

depending on whether you can make use of the zero % tax bracket you may be better tax harvesting the winner many times .

the reason is kicking the can down the road can create tax issues later .

we did that and harvested the losers all along and then in 2014 we sold the winner . well up to that point taxes were 15% on capital gains . by stalling the winner taxes jumped to 24% . 20% capital gain in this case and a 3.80% medicare /obama surcharge .

but wait it gets better . not only did taxes jump from 15 to 24% because we delayed harvesting the winners but in 2015 we retired and my wife went on medicare .

that delay and now taxable gain got her medicare premium increased in 2016 by 300 a month more . had we both been on medicare it would have been increased another 600 per month on top of the regular premium .

so harvesting gains can be more important than harvesting losses in quite a few situations .

as always , it is the things we don't know that end up causing us grief once we know them . who would have ever thought we would see a 600 buck increase a month in medicare for harvesting a loss insted of a gain when we had the chance to do either ,as well as another 9% in taxes
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Re: Tax Puzzle

Post by Libertarian666 » Mon Oct 23, 2017 4:16 pm

mathjak107 wrote:depending on whether you can make use of the zero % tax bracket you may be better tax harvesting the winner many times.
If I don't make any taxable income outside of SS this year, which so far seems to be what is going to happen, it looks as though I'll have about $40,000 available to take cap gains in the zero % bracket (including personal exemptions, etc.).

And I have that much that I can take, so obviously I'll do it.
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Re: Tax Puzzle

Post by farjean2 » Mon Oct 23, 2017 5:25 pm

I would take what's behind door number 2 - claim the loss. The rationale would be because death and taxes are the only sure things in the world and if I have the opportunity to reduce my taxes and save money today, I'm probably going to do it. No telling what is going to happen to those assets in the future. The asset you sold at a loss may very well go up in value during the time you are navigating this thing in which case you would regret it when the time came to buy it back. But you don't have a crystal ball to know this. The only thing you know for sure is that the tax man cometh, so I would play the one sure thing I know would be to my advantage.

Just my way of thinking. Not saying it's the right way - just mine.
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Re: Tax Puzzle

Post by moda0306 » Tue Oct 24, 2017 8:37 am

Take the loss (harvest) while you can. You get an ordinary income tax deduction for what may one day be a LTCG.

If you're going to similarly "harvest" a lower tax bracket (aka "harvesting gains) or are debating in engaging in a tax-hedging process, I usually recommend using Roth conversions for that.

The only time I would recommend harvesting modest/large amounts of capital gains unnecessarily is if unfavorable tax reform is on the way... and somehow I don't see Trump raising taxes on capital gains. If Bernie were president, my tone might be different (on multiple levels haha!).
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Re: Tax Puzzle

Post by mathjak107 » Tue Oct 24, 2017 10:11 am

i thought the same thing all those years too. i don't see capital gains taxes rising. boy was i wrong .also be careful when you are 2 years away from medicare age . these were two very expensive lessons i learned the hard way
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Re: Tax Puzzle

Post by farjean2 » Tue Oct 24, 2017 2:48 pm

mathjak107 wrote:i thought the same thing all those years too. i don't see capital gains taxes rising. boy was i wrong .also be careful when you are 2 years away from medicare age . these were two very expensive lessons i learned the hard way
Care to expand on that? Not really clear to me what you are saying.
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Re: Tax Puzzle

Post by mathjak107 » Tue Oct 24, 2017 2:57 pm

i already did in a post above

--------------------------------------------------------------------
"depending on whether you can make use of the zero % tax bracket you may be better tax harvesting the winner many times .

the reason is kicking the can down the road can create tax issues later .

we did that and harvested the losers all along and then in 2014 we sold the winner . well up to that point taxes were 15% on capital gains . by stalling the winner taxes jumped to 24% . 20% capital gain in this case and a 3.80% medicare /obama surcharge .

but wait it gets better . not only did taxes jump from 15 to 24% because we delayed harvesting the winners but in 2015 we retired and my wife went on medicare .

that delay and now taxable gain got her medicare premium increased in 2016 by 300 a month more . had we both been on medicare it would have been increased another 600 per month on top of the regular premium .

so harvesting gains can be more important than harvesting losses in quite a few situations .

as always , it is the things we don't know that end up causing us grief once we know them . who would have ever thought we would see a 600 buck increase a month in medicare for harvesting a loss insted of a gain when we had the chance to do either ,as well as another 9% in taxes
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Re: Tax Puzzle

Post by farjean2 » Tue Oct 24, 2017 3:20 pm

mathjak107 wrote:i already did in a post above

--------------------------------------------------------------------
"depending on whether you can make use of the zero % tax bracket you may be better tax harvesting the winner many times .

the reason is kicking the can down the road can create tax issues later .

we did that and harvested the losers all along and then in 2014 we sold the winner . well up to that point taxes were 15% on capital gains . by stalling the winner taxes jumped to 24% . 20% capital gain in this case and a 3.80% medicare /obama surcharge .

but wait it gets better . not only did taxes jump from 15 to 24% because we delayed harvesting the winners but in 2015 we retired and my wife went on medicare .

that delay and now taxable gain got her medicare premium increased in 2016 by 300 a month more . had we both been on medicare it would have been increased another 600 per month on top of the regular premium .

so harvesting gains can be more important than harvesting losses in quite a few situations .

as always , it is the things we don't know that end up causing us grief once we know them . who would have ever thought we would see a 600 buck increase a month in medicare for harvesting a loss insted of a gain when we had the chance to do either ,as well as another 9% in taxes
Sorry I missed that but the reasoning is so complicated and has so many variables that I still don't understand it. My advancing age (3 years beyond medicare) may have something to do with it.

Can you boil it down to some kind of formula based on your experience, whereby it is better to NOT take the loss when you can (assuming that's what you are saying)?
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Re: Tax Puzzle

Post by mathjak107 » Tue Oct 24, 2017 3:46 pm

THERE IS NO MAGIC FORMULA. it depends on so many factors including the size of the gain .

in a nutshell what you pay for medicare is linked to your taxable income from 2 years prior . the premium for the year can go as high as 3x the basic rate depending on total taxable income. selling assets when on medicare with lots of accumulated gains can really hurt you .

besides that the capital gains rate was raised from 15% to 20% above a certain point and if you hit a high enough taxable income with that gain there can be another 3.80% surcharge on top of it . we hit all of it and got the trifecta of taxes lol

that is as simple as i can make it .
Last edited by mathjak107 on Tue Oct 24, 2017 3:49 pm, edited 2 times in total.
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Re: Tax Puzzle

Post by Xan » Tue Oct 24, 2017 3:47 pm

Taking a loss is a method of deferring taxes: instead of paying taxes now, you pay them later.

That fails hard if tax rates go up in the future. It would have been better to pay taxes (at the lower rates) earlier rather than defer them to later.
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Re: Tax Puzzle

Post by mathjak107 » Tue Oct 24, 2017 3:49 pm

yep , i can be the poster child for that . i delayed 1 extra year and got hammered
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Re: Tax Puzzle

Post by moda0306 » Tue Oct 24, 2017 4:17 pm

mathjak107 wrote:yep , i can be the poster child for that . i delayed 1 extra year and got hammered
Had you engaged in enough loss-harvesting to have a sizable loss-carryover?

If so, it should have eaten up a good chunk of your gain. If not, it would appear your problem wasn't loss-harvesting, but refusing to harvest gains in modest chunks approaching a large cash-need and then doing it all at once.

I probably should've been clear that just because I advocate loss-harvesting doesn't mean you ignore sizable unrealized gains. You almost never want to blindly put yourself in any position where your AGI will rise significantly for one year. Is there something that caused you to have to liquidate such a large position?

Loss harvesting doesn't work all that well if you actually need to liquidate the gains shortly thereafter (especially since it's limited to $3,000 per year), but even then, you not only gain the timing element, but you harvest the loss as an ordinary loss, but usually recognize a long-term capital gain... so even with a strong hike in cap gain rates, one would often benefit from the arbitrage, depending on their ordinary tax rate. But that's only if it's a small loss compared to small gains. If you have a small loss next to BIG gains, along with a democrat pushing tax hikes, then gain harvesting can become more important than loss harvesting (esp if you'll need that money soon).

Also, low ordinary brackets can be harvested in a number of ways, one of which is doing sizable Roth conversions. This will also have the affect of lowering RMD's later in retirement, so I usually recommend using that as the main mechanism to "harvest" low brackets.

This all probably makes no sense to y'all or I'm missing some key aspect.
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Re: Tax Puzzle

Post by farjean2 » Tue Oct 24, 2017 6:28 pm

mathjak107 wrote:THERE IS NO MAGIC FORMULA. it depends on so many factors including the size of the gain .

in a nutshell what you pay for medicare is linked to your taxable income from 2 years prior . the premium for the year can go as high as 3x the basic rate depending on total taxable income. selling assets when on medicare with lots of accumulated gains can really hurt you .

besides that the capital gains rate was raised from 15% to 20% above a certain point and if you hit a high enough taxable income with that gain there can be another 3.80% surcharge on top of it . we hit all of it and got the trifecta of taxes lol

that is as simple as i can make it .
Ok, I get it. Ultimately the same advice as mine and others - take the loss. If you want a one-size fits all answer it's probably the best one, as far as I know - with the idea that a bird in the hand is better than 2 in the bush.

I don't yet pay anything for Medicare because I'm delaying SS for 2 more years until I'm 70 and I'm still on my wife's insurance policy who is 17 years younger. I had no idea about rates depending on taxable income in the 2 years prior and that's the first I heard about it. I thought it wouldn't matter as long as I can show that I was covered in the years I delayed claiming. Still hoping that is true and I'll qualify for the lowest rate.
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Re: Tax Puzzle

Post by mathjak107 » Tue Oct 24, 2017 7:29 pm

moda0306 wrote:
mathjak107 wrote:yep , i can be the poster child for that . i delayed 1 extra year and got hammered
Had you engaged in enough loss-harvesting to have a sizable loss-carryover?

If so, it should have eaten up a good chunk of your gain. If not, it would appear your problem wasn't loss-harvesting, but refusing to harvest gains in modest chunks approaching a large cash-need and then doing it all at once.

I probably should've been clear that just because I advocate loss-harvesting doesn't mean you ignore sizable unrealized gains. You almost never want to blindly put yourself in any position where your AGI will rise significantly for one year. Is there something that caused you to have to liquidate such a large position?

Loss harvesting doesn't work all that well if you actually need to liquidate the gains shortly thereafter (especially since it's limited to $3,000 per year), but even then, you not only gain the timing element, but you harvest the loss as an ordinary loss, but usually recognize a long-term capital gain... so even with a strong hike in cap gain rates, one would often benefit from the arbitrage, depending on their ordinary tax rate. But that's only if it's a small loss compared to small gains. If you have a small loss next to BIG gains, along with a democrat pushing tax hikes, then gain harvesting can become more important than loss harvesting (esp if you'll need that money soon).

Also, low ordinary brackets can be harvested in a number of ways, one of which is doing sizable Roth conversions. This will also have the affect of lowering RMD's later in retirement, so I usually recommend using that as the main mechanism to "harvest" low brackets.

This all probably makes no sense to y'all or I'm missing some key aspect.
it was a real estate holding that had the gains . it had to be sold all at once and it had no offsetting loses since it was a few hundred k . our senior partner gets to decide when it is sold not me .
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Re: Tax Puzzle

Post by WiseOne » Tue Oct 24, 2017 7:32 pm

It may help this discussion if you take a look at the original post - you'll see that the gains are short term only (< 1 year), and so do not benefit from capital gains tax treatment. Given the choice between taking gains taxed at ordinary income rates and tax loss harvesting, it's kind of a no brainer to do the latter.

Agree that in some situations, taking long term capital gains would be a good idea. In fact, alternating years would be a great approach: take capital gains in a different year from capital losses, so that the losses are set against ordinary income rather than investment gains.
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Re: Tax Puzzle

Post by Kriegsspiel » Tue Oct 24, 2017 8:18 pm

Tortoise wrote:Assume you bought two securities in a taxable account earlier this year, intending to hold them for at least a few years before selling. One has appreciated by 10%, and the other has declined by 10%.

However, it now appears you’ll need to sell some of one or both securities to raise cash in the next week.

A relative has promised to send cash to completely reimburse you, but must wait to do so until January 1st for tax purposes (so that he won’t have to pay gift tax on it). You plan to use that cash to buy back whatever securities you sold a couple of months prior.

Given that you must realize either a loss or a short-term capital gain, what would be your strategy — sell shares of the appreciated asset and pay the taxes on them, sell shares of the depreciated asset and claim the loss on your taxes, or a mix of both so that the gains exactly offset the losses? And what would be your rationale?
FWIW, in Magic Formula investing (Joel Greenblatt), he recommended selling losers within a year, and selling winners after a year.

Personally, I think I'd figure out what tax bracket I'm in. If I'm in a low one, I'd probably take the gain and pay regular income rate on the appreciation. Why bother tax loss harvesting this year when you might not even have any capital gains to offset before it expires? LTCGs are tax free if you have less than $75,900 (married) or $37,950 (single). And if your income is already taxed in the low brackets...

If I was in a higher bracket, I'd sell the loser and use it to offset the capital gains/highly taxed income ($3,000 of it) I'm sure to have before the loss expires.
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Re: Tax Puzzle

Post by Libertarian666 » Tue Oct 24, 2017 8:56 pm

WiseOne wrote:It may help this discussion if you take a look at the original post - you'll see that the gains are short term only (< 1 year), and so do not benefit from capital gains tax treatment. Given the choice between taking gains taxed at ordinary income rates and tax loss harvesting, it's kind of a no brainer to do the latter.

Agree that in some situations, taking long term capital gains would be a good idea. In fact, alternating years would be a great approach: take capital gains in a different year from capital losses, so that the losses are set against ordinary income rather than investment gains.
That's wonderful... if $3,000 worth of losses does anything much for you, as that's the limit to how much ordinary income you can offset.
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Re: Tax Puzzle

Post by Tortoise » Wed Oct 25, 2017 2:57 am

Thanks for the ideas so far, everyone! The puzzle I originally stated was intentionally oversimplified to elicit general principles rather than get hung up on minutiae. I suppose I should clarify a bit.

A more accurate description of the situation is that there's a good chance I'll be buying a home before the end of the year, and one of my relatives promised to gift me a particular sum toward the down payment; he has to wait until Jan 1st before gifting it in order to avoid the gift tax for 2017.

I currently have enough funds in my own account for the entire down payment including closing costs, but some of the funds are in the form of a PP (stock fund, gold, and T-bonds) earmarked for longer-term savings goals. If I had my relative's gift in cash today, then I could make the down payment in cash without having to sell any PP assets, but since the gift won't come until Jan 1st, I'll need to temporarily sell some of the PP assets and buy them back after Jan 1st using the gift money.

I'm a renter in a high income tax bracket (everyone in coastal Southern California is "rich" according to the government), so in general any tax breaks or deductions for the current tax year tend to be preferable to paying taxes now.

Here's a rough breakdown of the PP in my taxable account:

Stock fund: Some of it (~20%) was bought earlier this year and has gained 10%. The rest of it (~80%) was bought 5 years ago and has gained 78%.
Gold: Bought ETF shares from 2012-2014 that have lost an average of 23%. Had some physical gold, but it was lost in a tragic boating accident ;)
T-bonds: Bought about half of them from 2012-2014 and the other half of them earlier this year. They've all gained around 2% to 3%.

So of the assets I bought over a year ago, the winners are stocks (up 78%) and bonds (up 3%), and the loser is gold (down 23%).

To avoid paying more taxes and even pay a little less of them, it sounds like my best bet is probably to sell a mix of the gold and bonds such that my net realized loss is about $3k (the max that the IRS allows to offset regular income). Then I'll buy it back after receiving the gift from my relative on Jan 1st (making sure it's been more than 30 days to avoid a wash sale), and if gold and bond prices haven't moved too dramatically in the meantime, I'll actually come out slightly ahead by having reduced my 2017 taxable income by ~$3k?
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Re: Tax Puzzle

Post by D1984 » Wed Oct 25, 2017 3:43 am

Tortoise wrote:Thanks for the ideas so far, everyone! The puzzle I originally stated was intentionally oversimplified to elicit general principles rather than get hung up on minutiae. I suppose I should clarify a bit.

A more accurate description of the situation is that there's a good chance I'll be buying a home before the end of the year, and one of my relatives promised to gift me a particular sum toward the down payment; he has to wait until Jan 1st before gifting it in order to avoid the gift tax for 2017.

I currently have enough funds in my own account for the entire down payment including closing costs, but some of the funds are in the form of a PP (stock fund, gold, and T-bonds) earmarked for longer-term savings goals. If I had my relative's gift in cash today, then I could make the down payment in cash without having to sell any PP assets, but since the gift won't come until Jan 1st, I'll need to temporarily sell some of the PP assets and buy them back after Jan 1st using the gift money.

Could you not just request the relative loan you the money (draw up a brief contract for the loan and you both sign in front of a notary) at the short-term Applicable Federal Rate--which IIRC is currently around 1.27% APR which translates to maybe 0.27% total for the remainder of the year until January 1st 2018? Then, when the new year rolls around, have the relative make a gift to you of loan forgiveness of the entire loan amount since he/she was going to be gifting you that amount anyway?

Actually, if the loan is less than $10K, no interest would even need to be paid (i.e. a zero interest loan). If the loan is more than $10K but less than $100K, then you can still have it be a zero-interest loan so long as it is not used to buy investment property producing more than $1K of income a year (i.e. by "buying a home" you mean a personal residence and not a property to rent out) and if your total net investment income (dividends, interest, realized capital gains, etc) is less than $1K per year.

Doing it this way renders the whole issue of "what asset to sell" or "too big of a gift to fit in one year's gift tax exemption" moot.

I am neither a tax attorney nor a CPA, so as always, please consult with the appropriate professionals before doing the above and have them OK it.
Last edited by D1984 on Wed Oct 25, 2017 3:49 am, edited 2 times in total.
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Re: Tax Puzzle

Post by mathjak107 » Wed Oct 25, 2017 3:44 am

michael kitces wrote an excellent article on tax loss harvesting .

Executive Summary
Capital loss harvesting has long been a staple of investment tax strategy – so much that the Internal Revenue Code has special “wash sale” rules to ensure that the technique is not overly abused. Fortunately, though, the wash sale rules can be navigated effectively, allowing taxpayers some means to take advantage of available tax losses.
However, while tax loss harvesting remains a viable strategy, it is often greatly overvalued, as the true benefit is not the tax savings from harvesting a loss but merely the benefit of deferring those gains. In the meantime, the strategy has a non-trivial exposure to several risks, including the potential for the alternative investment held during the 30-day wash rule period underperforming the original investment, the possibility of negative tax arbitrage if the investment rebounds in the near term, and the danger that harvesting losses too effectively over time will drive the client’s future capital gains into a higher tax bracket! In addition, the fact remains that capital loss harvesting produces no benefits for clients who are eligible for 0% capital gains tax rates, and in fact potentially harms them; in such scenarios, clients should actually be harvesting gains, not losses!
Ultimately, this doesn’t mean that harvesting capital losses is a bad strategy, but it is a strategy where the risks must be carefully considered, as they can easily outweigh the relatively modest benefits!

https://www.kitces.com/blog/is-capital- ... vervalued/
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