Loss Harvesting with Inflation-Adjusted Gains

Tax Regime Change
October 6, 2020

aperio tax economics

In a White House press briefing in August, US President Donald Trump said he is “considering a capital gains tax cut.” While the administration has discussed a straightforward reduction of the long-term capital gains rate, the impact of such a change on the value created from loss harvesting is not particularly blogworthy.1

Furthermore, analysts were quick to observe that reducing the capital gains rate would require support from Congress but that indexing capital gains to inflation2 had the potential to accomplish the same objective and may be achievable via executive order.

The impact of taxing inflation-adjusted gains (IAG) is not as clear as the effect of directly changing the capital gains rate. So, in the same spirit as our previous post on Biden’s proposal, we used our After-Tax Back-Testing Analysis Tool to get a sense of the magnitude of the impact IAG might have had on historical after-tax performance.


We ran an index-tracking strategy with the Russell 1000 Index as both the benchmark and the universe from which we purchased securities. By staggering the start date, we generated multiple runs of the strategy under the current and IAG tax regimes started January 31, 1987, and ended August 31, 2020, applying current top marginal federal capital gains rates3 in calculating after-tax active return. We then looked at the performance over the first five, 10, and 20 years of the strategy and averaged the results across those different back-tests. Under the IAG regime, we used the consumer price index (CPI) to adjust the cost basis of the tax lots for inflation before each rebalance.


The charts below show the annualized average after-tax active return at various investment horizons for both Estate/Donation and Liquidation scenarios. As a reminder, the former scenario assumes no capital gains tax will be owed on unrealized gains at the end of the investment period, while the latter assumes the portfolio is moved to cash, which would realize all gains and losses and trigger capital gains taxes.

The general observation is that the IAG Regime resulted in higher average after-tax performance under both scenarios and across all time horizons, with the effect being more pronounced under the Estate/Donation scenario. This result makes sense: if inflation is generally positive over the investment period, then a portfolio’s cost basis would also increase, which would increase loss-harvesting opportunities. But what if inflation is not positive?

Deflationary environments are closely linked to economic recessions. If we assume the IAG proposal is symmetric in its treatment of the cost basis, then deflation would have the opposite effect: decreased cost basis and decreased loss-harvesting opportunities. Indeed, when we examined our back-tests, we found the IAG portfolio with the worst after-tax performance at a 10-year horizon was the one incepted on June 30, 2008, in the midst of the global financial crisis. Its after-tax performance underperformed the same Current Regime portfolio by 0.13% (annualized).


It is worth restating that tax proposals seldom become law in their original form, and we encourage investors to consider the broader impact of tax law changes beyond their impact on loss harvesting. Indexing capital gains to inflation could accomplish the intended objective of reducing the tax on capital gains, but without additional rules, it could prove to be a double-edged sword.

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Send questions or comments to blog@aperiogroup.com.

1 The expected tax benefit from loss-harvesting strategies is proportional to the capital gains rates. That is, if the capital gains rates were reduced by 25%, the expected tax benefit would also be reduced by 25%.
2 Indexing capital gains to inflation is another idea that has been discussed for some time.
3 Short-term: 40.8%; Long-term: 23.8%. These rates include the 3.8% Medicare surcharge (Net Investment Income Tax).

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