Recently, there has been a lot of doomsday talk about what will and will not be on the chopping block this fiscal cliff season. Among the key discussions have been possible increases in both the short and long term capital gains rates. As it stands, if we have no resolution by year end, tax rates on dividend payments are set to rise to an exorbitant 39.6%. On the other hand, with a resolution we can almost certainly expect a compromise that will, in one way or another, translate into higher short-term capital gains rate for the wealthy and higher long term capital gains for the rest of us. What does this mean for the market? Well looking back on 2012 we can definitely say it has been a great year for many equities across the indexes. Several have even seen gains far above 25% year to date [Bank of America (NYSE:BAC), Apple inc. (NASDAQ:AAPL), American International Group, Inc (NYSE:AIG), Citigroup, Inc (NYSE:C)], to name a few. This success has led many analysts to forecast a significant amount of profit taking which could send markets spiraling back downward.
Before panic sets in however, let's take a step back and look at this from afar. As it stands, long-term capital gains are taxed at a flat 15% for all those earning above the 15% income tax bracket. Short-term capital gains are taxed at ordinary income rates. Depending on your filing status these ranges can vary so I have added the link below for reference.
So lets take a look at a hypothetical example in order to measure the impact of these changes. Let's say you are a very wealthy investor currently in the top earning income tax bracket of 35%. Let's also say right now you are holding $400,000.00 of AAPL or AIG shares which you bought a few months back for $300,000.00. If you sold these shares right now you would expect to pay $35,000.00 in short term capital gains ($100,000.00 x 35%). However, if ordinary income rates for the wealthiest Americans increase by a hypothetical 3% in 2013, you would have to pay an additional $3,000.00 in taxes. If you add this factor to the typical year-end selling we see in December than many would argue we could have a fire-sale on our hands. There is however several buffers that could cushion this effect.
First is the "Wash Rule". The Wash Rule states that you can only book a loss from the sale of a stock given that you do not repurchase the same equity within the following 30 days of the sale. Therefore, in order to capitalize on selling for booked losses you would have to sit on the sidelines and watch your same equity for 30 days without re-joining in on the action. Given that a cliff resolution could likely translate into high profitability for many of these previous losers, I doubt investors will want to risk missing out on this approach. You could technically implement some lateral investing into another equity within the same sector but I have found that most people pick their favorites and have a tendency to stick to them.
Secondly, I believe the markets are still under-priced based upon this looming fiscal cliff and the ongoing macro concerns in Europe. Once these issues are truly resolved I believe we could see a significant upswing which could add far more than a potential increase in capital gains could take away. In this instance selling or moving your position to cash could only hurt you in the end.
Lastly, I would argue the percentage of investors who are actually in risk of being impacted by an increase in ordinary income rates. The rate increases only apply to America's top earners rather than the average investor who most likely does not fall in the highest income tax bracket. Therefore it is unlikely that an increase in short term capital gains will have any impact on most of us. An increase in long term gains however would apply to all of us; but I would argue that if you're long, you're long so why sell now and pay taxes when you can hold and continue to see gains tax-free.
So in closing, I only expect the usual December selling volume with maybe a slight 3-5% increase to account for the hype and come early 2013 I believe the markets will be in a much better place than they are today.