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Too Early to Tweak Portfolios for Capital Gains Tax Changes

Financial advisers talk about strategies for managing wealthy clients’ investment portfolios given potential a tax increase.

President Biden has proposed a large increase in the top federal tax rate on long-term capital gains and qualified dividends.

Under the American Family Plan, the tax rate on long-term capital gains and qualified dividends will rise from 23.8% today to 39.6% for those earning more than $1 million. The proposed plan would also alter the tax provision that lets investors avoid capital-gains taxes on appreciated assets if they hold them until they die.

According to the Tax Foundation, the top federal rate on capital gains would be 43.4% when including the net investment income tax. What’s more, the Tax Foundation noted that rates would be even higher in many U.S. states due to state and local capital gains taxes, leading to a combined average rate of 48% compared to about 29% under current law.

According to the Tax Foundation, “a high combined capital gains tax rate would influence when taxpayers decide to sell assets and realize the gain.”

Given that, what, if any, actions are financial advisers taking or planning to take with their wealthy clients’ investment portfolios? Do they plan to sell appreciated assets now given the lower capital-gains rate? Are there other strategies and tactics to consider?

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At this point, most financial advisers say it’s too premature to take any action on these proposals. “Until they actually make it into a bill, and we see that bill start to get some traction as it moves through Congress, it's too early to try to handicap the odds of these proposals passing or what they'll actually look like if/when they pass,” said Andy Panko, a certified financial planner with Tenon Financial.

At this stage, Panko said President Biden’s proposal could merely be “feelers” floated out to gauge reactions and to kind of take the temperature of Congress and the public. “If there is a lot of public push-back, then I don't think these proposals will end up having legs,” he said. “Or at least, they may be watered down some.”

For example, Panko said there is nothing that says these proposals are all or none. “If they do ultimately make it into law, it's possible they'll be heavily revised from what was originally proposed,” he said. “For example, maybe the capital gains tax only goes up to a top rate of 30%, and maybe it only applies to those with wealth or gains over a higher threshold than what was originally proposed.”

The same thing, he said, applies with repealing the step-up in basis. “Perhaps it only gets partially removed, or only applies on estates over a substantial size,” he said. “Additionally, I don't see how removing step-up in basis can be expected to actually be implemented.”

For example, it's nearly impossible to try to cobble together an accurate basis for shares someone bought 30 or 40 years ago, said Panko. “So how can heirs be expected to figure out the basis of inherited assets in that case?” he asked.

Other financial advisers share Panko’s point of view. “I think it’s premature to take any deliberate action at this time,” said Douglas Boneparth, a certified financial planner with Bone Fide Wealth. “Currently, there’s nothing in place and we’re far away from any changes.”

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And Larry Stein, president of Disciplined Investment Management, said he’s not taking any actions yet on this, either. “It's too early and my clients are very tax-sensitive,” he said.

When to Take Action

So, is there anything to do now but sit and wait?

For his part, Boneparth said now, at the very least, is perhaps a good time to identify what significant gains exist so you can be ahead of the curve should things look like they’re about to change. “Taking a proactive stance is not a bad idea and is a value generator,” he said.

And, if and when these proposals do start to materialize, that’s when Panko said it would make sense to start potentially taking some proactive actions, such as maybe selling some appreciated assets now while the current long-term capital gains tax rates are still in place and then simply repurchase them to "reset" the basis.

Or, in the case of step-up in basis potentially going away, perhaps it would make sense to start gifting or donating assets that you may have otherwise planned on taking to the grave, said Panko.

Some advisers, however, are not taking a wait-and-see approach.

When President Biden originally floated the idea of increasing capital gains last year when he was on the campaign trail, Cheryl Costa, a principal with Woodside Wealth Management, reached out to clients who would be impacted should that change occur.

Those people, she said, were mostly in the tech/pharma industries and they held concentrated positions in their company’s stock. “We talked about the possibility of selling shares in 2020 or 2021 because their personal situations were such that they would trip the $1 million threshold,” said Costa. “At that time - and even now - there was no guarantee that the change would go through but I do think it helped tilt the scales for some people who knew that they were walking a fine line with concentrated stock positions.”

Costa said she’ll be contacting those clients again once more details are known. “It is my guess that a few may accelerate their sales in 2021 and I think that is a reasonable plan of attack,” she said.

She gave the following example: If someone with a concentrated position was going to sell over the next few years anyway, pulling some of those sales forward into 2021 locks in a reasonable cap gains rate and the worst that can happen is that rates don’t go up but they are still winners because they diversified a concentrated position.

In addition, she noted that the loss of the step up in basis would be a nightmare in several ways. “Hopefully that part doesn’t stick,” she said.

“We are also having more in-depth discussions with the clients who will be negatively impacted by a decrease in the estate tax exemption,” Costa said. “Biden has proposed reducing the estate tax exemption to $3.5 million. Should that occur, many people may want to accelerate gifting. Gifting is forever, though, so I think people will wait until later in the year to act on that.”