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Yellen's idea to tax unrealized capital gains

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So Elon would use his TSLA dividends to pay the tax on his unrealized TSLA gains? :)


That works for assets held in brokerage accounts - at least going forward. Still have all the historical assets they hold where they don't know the cost basis. Paying an annual unrealized gain tax would make tracking the basis complicated, since I assume each year the tax basis would change as you pay tax on the unrealized gain. After 30 years of holding a stock there would be 30 adjustments to the tax basis.

What would you do for assets not held in brokerage accounts? Real estate valuations are complicated, especially with partial-ownership discounts. Right now they are typically valued at sale or death - not every year - and there is often litigation that can take years to resolve.

Seems complicated and subject to cheating to me. Though cheating on the valuation for the annual unrealized gains tax might defer the tax, but eventually it would get paid when the asset is sold.
As a default, the basis starts at zero. The accounting burden is on the taxpayer to document a higher basis. It's trivial for brokerages to provide this to client. For other more complex situations, taxpayers will find it beneficial to hire a competent accountant.
 
I tend to like the idea that a certain portion of unrealized cap gains must be added to basis and taxed each year. For example, suppose at the end of the year, I'm sitting on $11M in Tesla with a basis of $1M. Suppose the rule is to tax 10% of the unrealized. So I pay say 20% tax on the 10% of my $10M in unrealized gains, just $200k. But now my basis increases by $1M. So going into the next year my new basis on $2M on $11M. Suppose Tesla declines, and by the end of the year my position is worth $8M. Now my unrealized is $6M, so my tax is 20% on $600k, or $120k. Thus my tax bill has declined in the second year because my investment lost value. This makes it easier to buy more shares when the price down. But more importantly for tax policy, only taxing 10% of unrealized gains avoids the potential for unrealized losses, which would not be taxed in a given year. Investors that tend to hold positions long enough will tend to pay a reliable tax each year.

I also think we should get rid of the distinction between long-term and short-term cap gains and dividends. All should be taxed at the same rate to keep things simple. I don't believe we need to reduce rates to induce a preference to hold investments longer. Being able to differ 90% of your unrealized gains each year has a certain time value to it. If your portfolio grows at 20% year, being able to defer a $1 tax for one year has a present value of $0.833 = $1/1.20. So you're getting a 16.6% break on your taxes by not realizing your cap gains in a year. That ought to be incentive enough to keep holding the bulk of your investments.

We also see that forcing 10% of unrealized gains to be realized and taxed simply puts a limit on how long you can keep deferring your taxes. It means that on average you can defer cap gains 10 years ( = 1 / 10%). In terms of long-held estates, the unrealized gains will mostly be gains over just the last ten years, not multi-decade gains. Heirs will not inherit such large unpaid tax bills.
How could changing capital gains taxes raise more revenue?

This is a pretty good discussion of the advantages/disadvantages of an accrual based tax on capital gains.

My proposal is effectively a modification of the accrual approach allowing a certain fraction of the tax liability to be carried forward to the next year (90%, which might be too much).

Another idea is a variation on the retrospective approach, which calculates the economic value of deferred taxes and adjusts for that upon liquidation of the asset. In effect one is paying capitalized interest on taxes not paid as the gains accrued. This is an economically logical approach that avoids liquidity issues with the accrual approach. What I would propose within this framework is that investors would have the option to pay this interest on deferred taxes upfront. Suppose, for example, that the yield on 10-year Treasury, 1.2%, is the deferral interest rate, and I'm sitting on $10M in unrealized capital gains, subject to 20% tax rate. So could:
  • sell these assets and pay $2M in taxes, or
  • defer the taxes to the next year by paying 1.2% on the $2M deferred unrealized cap gains, specifically, pay $24k to defer, or
  • defer the taxes to next year by capitalizing the $24k interest payment, which is effectively, a reduction of basis by $24k.
Effectively with either deferral, I am allowed to finance my deferred taxes by an interest rate that is based on risk free rate on a suitable tenor of Treasury yields. If I make the interest payment, I am at least allowing the federal government to make bond payment on national debt while waiting for me to eventually pay my cap gains tax. If I capitalize the interest, then I am at least compensating the government for the interest payments it had to pay while waiting for me to settle the tax liability on liquidation of the asset.

By contrast, the current cap gains approach allows free deferrals indefinitely, while other tax revenues are used to make payment on the national debt that finances the deferral my cap gains tax. I think accrual based taxation is inherently a more equitable way to distribute the tax burden over time. There is a clear public cost to deferral, which includes but is not limited to the cost of the national debt. So there can be mechanisms to allow tax deferral at an appropriate cost or to limit the temporal scope of deferral as I have proposed.

Those of you who worry about the tax situation of Elon Musk should take heart that he can easily borrow against his assets to pay his taxes just as he does for any other living expense. The reality is that it is cheaper for him to borrow against his Tesla shares to defer his tax bill than to pay taxes as his wealth grows. This demonstrates just how valuable tax deferral under the current tax scheme is to the ultra wealthy. And, I too, a petty Teslanaire, am also discovering that it is cheaper to borrow against my shares than to trade them.

Is it really good for investors to lock-in assets for decades. Sure, Tesla is really worth holding much longer. But the S&P index is full of really lame, go-nowhere stocks that investors hold onto just so they can avoid the taxes and pass pass on to their heirs. From an economic point of view, this is not an efficient use of capital. It builds up a bias in favor of long-held stocks like XOM and GM and against new, rising, innovative companies like TSLA or TDOC. An accrual approach to taxation could free up this ossified, tax-avoidance capital to do much better things in a dynamic economy.
 
Don't forget the net investment income tax of 3.8% for those taxpayers with income > 200K (single) and 250K (joint). Many of us might find ourselves involuntarily thrust into that surtax.

Also don't forget the states that have automatic conformity to federal law changes. More tax dollars will be flying out the door. Finally, those in states without automatic conformity to federal changes will wind up tracking two bases: federal and state.

Then there are those corporations that don't have publicly traded stock like Hallmark and Cargill and Mars Candy. What about Zuckerberg and his ginormous ownership of Facebook B shares that are not traded but have, what, 10 times the voting rights?

Brokers track federal basis only. It is rare, but not unheard of, for taxpayers to have a federal basis and a different state basis for securities.

It just might be better to let sleeping dogs lie. :)
 
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