Tax Economics: When—and When Not—to Take Gains

The bottom line

• Direct Indexing seeks to generate investment returns similar to those of an index fund before taxes and fees and seeks to improve after-tax returns through systematic tax-loss harvesting (TLH), by reducing net capital capital gains - and overall tax liability - on the client's federal tax return.
• TLH involves realizing losses and avoiding realizing capital gains. Generally, we find that requests to intentionally realize capital gains are often sub-optimal, and if executed, may reduce an investor's after-tax wealth.  Absorbing capital loss carryovers and increasing deductability of charitable donations are some of the more frequent sub-optimal examples which may not warrant the potential transaction costs associated with liquidations.
• Risk and tax bracket management may be valid reasons for realizing gains but investors should be keenly aware of unintended consequences like moving into a higher marginal tax bracket and the effect of large capital gains on Alternative Minimum Tax (AMT) thresholds.
• As with any planning, the optimal outcome should reflect each investor’s financial circumstances.  Timing, costs, and available alternatives are critical considerations when assessing potential benefits and drawbacks.

We at Aperio Direct Indexing systematically tax-loss harvest throughout the year for our clients who have selected strategies with tax-loss harvesting, as we believe that realizing losses and avoiding (or deferring) realizing gains, depending on each taxpayer’s situation, is usually economical. But should realizing gains always be avoided, or do client requests to deliberately realize gains make economic sense in some situations? In most cases, the answer is no, and if executed, these requests can reduce an investor’s after-tax wealth. Some of the more common misguided scenarios we examine below involve attempts to monetize the charitable deduction, absorb capital loss carryovers, and accelerate wealth transfer planning strategies. We propose viable alternatives and close with a review of what we think are valid reasons for deliberately realizing gains. These include accomplishing risk management objectives, implementing factor or values-aligned exposures, tax bracket management, and managing income for endowments and foundations.

General considerations

Before diving in, let’s start with a general framework we believe one should consider when deciding whether taking gains is warranted:

Finally, understanding potential unintended consequences of a liquidation is imperative. After all, capital gains stack on top of ordinary income, and depending on an individual taxpayer’s financial circumstances, realizing capital gains could bump a taxpayer into an alternative minimum tax (AMT) regime or may reduce other potential benefits such as itemized deductions or credits.

Offsetting charitable gift deductions

Some of the most common examples of potentially misguided reasons to realize gains involve charitable gifting.¹ Consider the following scenario: A client with a net worth of $10,000,000 is planning to make a charitable gift in the amount of $1,000,000, and in the year the gift is made, the client has $0 income.²

The default recommendation from the investor’s tax advisor would normally be to make a gift of long-term capital gain (LTCG) property directly to the charity. However, given the absence of income, the donation of LTCG property would result in a $1,000,000 carryforward (subject to the 30% adjusted gross income, or AGI, limitations). In search of a better alternative to an outcome that provides no cash benefit this year, the tax advisor explores potential methods to monetize the charitable deduction and recommends that the investor contact Aperio to generate income by realizing capital gains in their portfolio to make a cash donation. Any income generated would permit a deduction in the current year and limit the large carryforward to future tax years.

Default approach

Requested approach (cash gift)

The issue with this logic is that only a portion of the realized gain will be offset by the deduction.³ The value of the deduction is further limited by the type of income it offsets—in this case, long-term capital gain.^4,5 With only a portion of the gain protected from taxation, realizing gains to generate income will result in a suboptimal outcome and potentially large out-of-pocket payment to the Internal Revenue Service.⁶ In this particular situation, the investor is better off donating the appreciated security, saving the taxes associated with liquidation, and carrying forward the deduction for use in future tax years.⁷

Capital loss carryovers

We also routinely receive requests to realize gains to absorb capital loss carryovers.⁸ In scenarios where these carryovers are utilized to accomplish risk management objectives or expedite portfolio transitions, these requests can be valid. However, it’s important to keep in mind that, unlike some net operating losses (NOLs), capital loss carryovers do not expire for individual taxpayers.⁹ They can be carried forward indefinitely. Absent a valid reason to offset losses, these transactions may lack economic substance and may not warrant the potential transaction costs associated with liquidations.

Wealth transfer planning

Finally, a unique scenario involving a common wealth transfer planning tool: the grantor trust.¹⁰ Grantor trust entities such as grantor retained annuity trusts (GRATs) seek to take advantage of the differences between definitions of a “completed gift” under the income and estate tax codes. These strategies have benefited from the recent low-interest-rate environment and longer-term bull market, and in many cases, the assets in these vehicles are highly appreciated but, unfortunately, not eligible for a step-up in basis upon the grantor’s death. Herein lies the quandary: Should the grantor instruct liquidation of the assets? If the assets remain in trust, the future capital gains tax burden would fall to the beneficiaries, which could otherwise indirectly decrease the amount of tax-free wealth transferred. Conversely, if liquidated, the grantor would be subjected to a potentially substantial capital gains bill.

Consider the following alternative: Swap the appreciated property for cash or other high-basis property (bond portfolio, etc.). Since the grantor is treated as owner of the trust for income tax purposes, the swap is viewed as moving assets from one pocket to the other. This transaction alleviates the concern of future gains burden for the trust beneficiaries and, in swapping the assets, allows the appreciated property to flow through the grantor’s estate, thus making it eligible for a step-up in basis! This approach can be quite powerful but does rely on two BIG assumptions: 1) the trust agreement grants the power to swap property and 2) the grantor trust rules remain intact as currently written (a big assumption given recent tax proposals in Congress!).

Economically sensible reasons for realizing gains

So, when would taking gains financially benefit an investor? Well, as evidenced by the list of considerations above—it depends! In our experience, though, taking gains can make sense in several scenarios.

Realize gains to …

First among the reasons to take gains is a desire to manage risk. A capital gains budget can be used to reduce tracking error within portfolio strategies or to speed up portfolio transitions. This strategy can be particularly helpful when funding a tax-loss harvesting portfolio with appreciated legacy securities. In the absence of available offsetting losses, realizing gains may also be useful to rebalance an investor’s portfolio back to strategic target asset allocations, to implement target factor exposures, or to align a portfolio with an investor’s values preferences.

Outside of risk management, tax-oriented motivations may also be valid. For example, investors with income that varies widely year to year may wish to implement tax bracket management. In doing so, one might accelerate capital gains in lower-income years to take advantage of the lower 0% or 15% capital gains brackets. Although potentially useful, bracket management is dependent on a clear picture of overall income. In years when gains realization is part of the overall strategy, one should be keenly aware of capital gains “bump zones”¹¹ and the effect of large capital gains on AMT thresholds.

Another tax motivation could be a need to absorb an expiring net operating loss. Cushioned by the NOL, any realized gains could be used to accomplish risk management objectives (see above) or to raise the cost basis of an investor’s portfolio to facilitate additional opportunities to harvest capital losses. This option is particularly helpful when considering more unique strategies such as tax-rate arbitrage,¹² which seeks to take advantage of the favorable differential that may exist between short-term losses being offset at ordinary income rates and realized long-term capital gains taxed at preferential rates.

Finally, from the nontaxable world of endowments and foundations, in some situations, entities might find generating a certain amount of realized gains helpful to satisfy certain bond covenants, and separately managed accounts can be an easy way to manage toward targeted income levels each year.

Final thoughts

To recap: Realizing capital gains can be an incredibly effective tool when used to accomplish targeted goals. Manage risk. Expedite transitions. Align exposures. But absent specific objectives, one should seriously consider all available options before broadly realizing gains. Doing the math helps and can potentially reduce unnecessary turnover, transaction costs, and taxes!

To learn more about Aperio’s approach to tax- and risk-aware charitable giving and other solutions for protecting after-tax wealth, see “CRUTs as Tools for Advanced Risk Management” and “Aperio Tax-Loss Harvesting Strategies.”

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