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

Active Tax Management
November 21, 2022

We at Aperio 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.



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. Although not the focus of this blog post, it is worth mentioning that some states (New Jersey and Pennsylvania, in particular) do not permit capital loss carryovers. In any year when an investor is expecting a net capital loss under these state tax regimes, running the math to determine if realizing gains could be a beneficial endeavor is worthwhile.
 
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.”


Send questions or comments to aperio.blog@blackrock.com.

1 Lincoln Fleming, “When Philanthropy Meets Portfolio Tax Management,” Aperio Group Blog, November 3, 2022.

2 The proposed scenario assumes that (1) a long-term capital gain of $1,000,000 is realized, (2) the realized capital gain represents the investor’s only income, and (3) our investor is subject to top marginal ordinary income and capital gains rates.  For simplicity, we do not consider state income taxes.

3 For gifts made to a public charity, the deduction for LTCG property is limited to 30% of AGI. The deduction is limited to 60% of AGI for cash gifts. In this example, the investor is entitled to a current year $600,000 deduction: $1,000,000 x 60% AGI limitation = $600,000 and a $400,000 carryforward to future tax years.

4 Tax benefit calculation: $120,000 = $600,000 deduction x 20% tax rate for LTCG.  Note: If a subsequent gift was LTCG, the deduction would be limited to 30%, and tax benefit would be reduced to $60,000 = $1,000,000 x 30% x 20% tax rate.

5 Tax rate used to calculate tax benefit does not include net investment income tax (NIIT). Charitable deduction does not offset NIIT.

6 Tax cost calculation: $238,000 = $1,000,000 x [20% tax rate + 3.8% NIIT].

7 An individual taxpayer may carry forward for five years his or her charitable contributions that exceed the deductible ceiling for the year of the contribution.

8 Lincoln Fleming, “Too Much of a Good Thing? Planning for Capital Loss Carryovers,” Tax Notes Federal 176, no. 1 (July 4, 2002): 53.

9 Capital loss carryovers carry over indefinitely but do lapse at death.

10 Lincoln Fleming, “The Shifting Sands of Wealth Transfer Planning,” Aperio Group Blog, April 5, 2022.

11 Capital gains bump zones occur as gains cross from the 0%‒15%, the 15%‒18.8%, and the 18.8%‒23.8% brackets.

12 Lisa R. Goldberg, Taotao Cai, and Pete Hand, “Tax-Rate Arbitrage: Realization of Long-Term Gains to Enable Short-Term Loss Harvesting,” Journal of Investment Management 20, no. 3 (2022): 1‒20.

Important Notes:
Aperio Group, LLC, provides this presentation for informational purposes only and for the sole use of the recipient. The information is provided with the understanding that we do not guarantee its accuracy, and are not engaged in rendering legal, accounting, or tax services.  We recommend that all investors seek out the services of competent professionals in these areas. The strategies and/or investments referenced may not be suitable for all investors because the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. None of the examples should be considered advice tailored to the needs of any specific investor or a recommendation to buy or sell any securities.
Investing involves risk, including possible loss of principal. Asset allocation and diversification may not protect against market risk, loss of principal or volatility of returns. There is no guarantee that any investment strategy discussed herein will work under all market conditions. Many factors affect performance, including changes in market conditions and interest rates, as well as other economic, political, or financial developments.
You should not assume that investment decisions we make in the future will be profitable or will equal the investment performance of the past. With respect to the description of any investment strategies, simulations, or investment recommendations, we cannot provide any assurances that they will perform as expected and as described in our materials. Past performance is not indicative of future results.
Any tax information provided herein is for illustrative purposes only and does not constitute the provision of tax advice by Aperio. Due to the complexity of tax law, not every single taxpayer will face the situations described herein exactly as calculated or stated, i.e., the examples and calculations are intended to be representative of some, but not all, taxpayers. Since each investor’s situation may be different in terms of income tax, estate tax, and asset allocation, there may be situations in which the calculations would not apply. Please discuss any individual situation with tax and investment advisors first before proceeding. For those clients using tax advantaged indexing, taxpayers paying lower tax rates than those assumed, or without taxable income, would earn smaller tax benefits from tax-advantaged indexing (or even none at all) compared to those described.

MKTGM1122U/S-2604984

© 2022 BlackRock, Inc. All rights reserved.

This material is provided for informational purposes only and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are subject to change at any time without notice. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations.

This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of yields or returns, and proposed or expected portfolio composition. Moreover, any historical performance information of other investment vehicles or composite accounts managed by BlackRock, Inc. and/or its subsidiaries (together, “BlackRock”) included in this material is presented by way of example only. No representation is made that any performance presented will be achieved, or that every assumption made in achieving, calculating or presenting either the forward-looking information or the historical performance information herein has been considered or stated in preparing this material. Any changes to assumptions that may have been made in preparing this material could have a material impact on the investment returns that are presented herein by way of example. Past performance is no guarantee of future results.

The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy.

MKTGH1022U/S-2467148