While it seems unlikely that Congress will vote to end the Bush era tax cut extensions in the foreseeable future, with the economy and Americans continuing to suffer, it seems inevitable that one day Bush's low tax rates on capital gains will have to be hiked substantially. That day could come when signs of true economic recovery are amply evident. Both corporate earnings and stock prices will likely have rallied hard from current levels. Then we will be looking at the large unrealized gains in our portfolios through the perspective of the large latent tax bill they harbor. How to prepare for that day? One way is to give yourself tax choices for the future. Specifically I will offer a 'doubling up' tax strategy to consider for large unrealized gainers in your portfolio that you remain very bullish on and so would like to hold rather than sell.
Suppose in 2009, during the depths of the market's despair, you picked up 100 shares of IBM (IBM) at $90 a share. Today your shares are each worth $193 and by some measures might still be viewed as cheap. (Warren Buffett seems to think they are, having loaded up heavily in 2011.) You thus have an unrealized gain of $103x100, or $10,300. So at today's 15% long-term capital gains rate there is a latent tax bill of $1545 due when you sell. However, when the Bush tax cuts are let to expire that tax bill could, depending on your bracket and any new deficit-reducing legislation, be perhaps as high as $5000 or more on the same $10,300 gain.1 Then what to do if you actually want to hold the stock rather than sell? Suppose you believe the shares will continue to rise long term, but that by then tax rates are likely to be far higher.
The simplest thing to do to ensure paying the low 15% rate is simply to sell the shares before the Bush cuts expire in order to trigger the tax. Then you can buy the shares back immediately. Don't worry about IRS wash sale rules and thirty day holding periods--they only apply for capital losses, not gains. The IRS is happy to take your tax revenues any time you want to sell to take a gain, and then you are free to buy back the position any time. A problem with this is that if you use the proceeds of the sale to cover the 15% tax, the fact that your position is presently reduced to 85% of what it was will hurt dearly in terms of inhibiting future compounding (it's even worse if your state's income tax also applies). So pay the taxes from other cash if you can so your position doesn't shrink.
However if you are confidently bullish on IBM long term and so wish to hold the shares, and if extra idle cash has been piling up, here's an interesting strategy: double up the position. That's right, buy more shares at $193 today. This gives you tax options for the future. While the number of additional shares you wish to buy need not be another full 100, for illustrative purpose let's assume you double up by buying 100 more shares at $193. Then your total position is 200 shares. Now let's explore the three possibilities.
Scenario 1 - shares continue to climb in price: Suppose IBM continues to climb to say $225. You have nice gains on both the 100 shares bought at $90 and the 100 shares at $193. Then suppose Congress raises the gains rates drastically, to go into effect in 180 days. What to do? You might sell all the $90 basis shares before the rates change. You'll grab the low 15% tax rate on the whole move from $90 to $225. You'll still own 100 shares for the long term (maintaining your original position size) but instead of a tax basis of $90/share your basis on the 100 shares has in effect moved up to $193/share. When you sell one day under the new, high rates you'll thus escape paying the high rate on $103 worth of gain per share.
Scenario 2 - share price goes nowhere: IBM shares remain around $193 for years. It is unfortunate you were wrong and your capital is tied up earning only the dividend, but at least the 1.8% dividend yield handily beats a money market yield. You are prepared for any gains rate changes that may come along by having 100 shares each at widely disparate cost bases. This gives you the choices outlined in the other two scenarios when the share price eventually does move one way or the other.
Scenario 3 - share price tanks: Suppose IBM shares drop to $150. Here it gets interesting because if gains rates are then replaced by much higher rates, you are in the position to either continue to hold the 200 shares and pay no tax, or to sell just 100 shares. If you sell 100 you can choose between a capital gain of $60 per share or a loss of $43 per share. If selling the shares with the $60 gain, you can buy the shares back immediately to initiate a new basis of $150 for the future rather than the $90 basis. If instead selling the $193 basis shares, within one year of purchase, then the $43 loss is considered short term and thus can offset other income at your marginal rate for your bracket (as high as 35%). While selling for a loss hurts, in some instances it may be worthwhile in order to offset income at your 35% tax bracket. In essence it means that the government is subsidizing 35% of your loss. Remember that if you wait 30 days from selling the shares in order to benefit from the tax loss, you can then buy the shares back (wash sale rule). If you are fortunate you'll get a price at or lower than the price you sold at 30 days earlier. Then the tax benefit may actually become a pure windfall in offsetting ordinary income (provided you never sell the shares you bought back, thus never triggering a future gains tax).
Keep in mind that there is no magic sure-fire money to be had in this 'double up' strategy. It does however provide options in later choosing shares at the most favorable cost basis for advantageous tax treatments. By using the 'specific identification' method of tax lot accounting you can in essence reduce the 'doubled' position back to your original position in size, but at a higher basis. This can keep unrealized gains from snowballing so large over time that the future potential taxes on selling are so hobbling that you'll never feel you can sell. Consider Warren Buffett's dilemma of effectively never being truly at liberty to sell his $50 billion stake in Berkshire Hathaway (BRK.A), of which probably over 99% is unrealized capital gain! (Not that Buffett ever would sell.)
The key is that you make sure your 'doubling up' is still buying at a price that one future day will prove to be a bargain. By doubling up of course you are also doubling your risk in the position should something go wrong. So to me it makes good sense to use this strategy for shares of diversified funds where company-specific bad news risk has been diversified away. (SPY) and (DIA) come to mind as good candidates to consider. I have also personally used this 'double up' strategy successfully with diversified CEFs including (GAB) and (RVT).
1 If you think such a whopping 48% gains rate could never happen, think again. We enjoy today some of the lowest taxes on high income earners since the income tax began. But for the thirty-five years after World War II, the top income tax bracket ranged from 70% to 92%. So in historical context, today's 15% top rate on gains is truly a gift.