Most tax savvy investors are familiar with the concept of harvesting losses is order to reduce their tax bill. Potential changes on the horizon to capital gains tax rates should have investors thinking about a different kind of strategy that might make sense for some of their long held assets - harvesting *gains*.

While it's difficult to know precisely where the tax code is headed, it isn't difficult to guess directionally where tax rates are most likely going over the next several years. Currently, there are two increases scheduled to begin in 2013 that affect long term capital gains. For simplicity, we'll focus on taxpayers in the highest brackets:

- The top tax rate on long term capital gains will rise to 20% from 15%
- Taxes associated with Health-Care Overhaul (HCO). The HCO will be funded by a tax on unearned income. Beginning in 2013, individuals with earned income over $200,000 ($250,000 for married couples filing jointly) will pay additional taxes on unearned income (capital gains, dividends, interest, etc.) at a rate of 3.8%.

The combined increase in capital gains tax and the inaugural HCO tax will increase the rate on long term capital gains from 15% to 23.8%.

If you have long term investments that need to be liquidated over the next few years, the incremental 8.8% tax needs to be seriously considered. Unless you expect to hold an asset for an extended period, the after-tax value may be highest if the asset is sold in 2012, thereby locking in the 15% capital gains tax rate.

Why should the holding period matter? If we assume the 8.8% increase is permanent, wouldn't it always make sense to maximize present value by selling today at the lower rate? Not necessarily. Taking the 15% tax hit today on the long term gains reduces the investment's potential pre-tax return compounding. The compounding effect can be significant if the time frame is long enough and the annual return is high enough.

There are many variables to consider when evaluating whether or not to harvest gains this year. At a minimum, you need to consider:

- How long do you plan to hold the asset? If you need to sell in the next few years in any case, holding the asset makes it harder to offset the negative impact of higher future tax rates.
- What are your views on future tax rates? The particulars may change, but a strong case can be made that future tax rates are going up and remaining higher than current rates for quite some time.
- What is your expected annual return of this asset? If the expected return is reduced by high management fees, all the more reason to take the tax hit today. Reinvest in something with a better expected return net of fees.
- Do you currently have "concentration risk" in this asset? If so, selling this year and reallocating the proceeds to a more diversified portfolio can help bring your overall portfolio closer to the "efficient frontier" by offering a higher risk-adjusted return.
- Do you currently have tax loss carry forwards that would offset any recognized gains? If so, then the benefit of harvesting gains today is reduced or eliminated (tax loss carry forwards become more valuable in a higher tax environment; using them has an equal and opposite "opportunity cost").

With all these degrees of freedom (and there may be more specific to an individual's tax situation), the decision to harvest gains can be complicated to evaluate and certainly subject to forecasting error.

However, complexity doesn't mean one can't develop a useful framework to evaluate the decision. One simply needs to limit the degrees of freedom under consideration. In the following framework, the assumptions are as follows:

- Change Tax Rate - For simplicity, we assume the
**8.8% increase**in long term capital gains rate does take place next year, and holds indefinitely. - Expected Return -The Capital Asset Pricing Model (CAPM) tells us the Expected Return (ER) of an asset is the sum of the Risk Free Rate (RF) and the Market Risk Premium (Rm-Rf) multiplied by the beta of the asset, where beta is a measure of asset's sensitivity to market risk. Sadly, expected returns aren't what they used to be. A measure of long term Rf is currently about 2%, and current estimates of the Market Risk Premium are around 4%. Therefore an asset that is roughly as volatile as the market would have an expected return of about 6% (more volatile assets should, in theory, have higher expected returns). For illustrative purposes, we'll start with a
**6% expected return**assumption.

The variable to 'solve' for in this framework is: *How long will the incremental investment take to compound at a higher return to overcome the higher capital gains tax rate effective in 2013*?

The chart below shows the cost/benefit of selling the asset in the future compared to selling in 2012, given a 6% expected return assumption and the 8.8% incremental tax. Bars below zero indicate a negative impact for selling in those years (and paying 8.8% higher tax) versus selling this year.

As you can see, if you need to sell between 2012 and 2021, it would be optimal from an after-tax perspective to sell and recognize the gain in 2012, then reinvest the after-tax amount. If this asset would likely be held beyond 2021, foregoing the sale this year makes sense because you will recoup the incremental taxes in the higher return on the asset. To clarify, this analysis does take into account that even when first selling in 2012 at the lower tax rate, all *future* gains from that point on will be taxed at the higher future rates.

The next chart allows for a broader range of assumptions for the expected return of the asset; higher expected returns shorten breakeven time frames.

As the expected return of the asset increases, the breakeven date moves closer to the present, though it's still several years away. Using a 10% expected return, for example, shifts the break even timing from 2021 to 2018, six years from now. It's therefore important to note that in most circumstances, selling an asset with unrealized long term gains in 2012 would be better from an after tax perspective than selling in the next six years. One would need to assume an extremely (and arguably, unreasonable) high expected return in order to be better off selling between 2013 and 2018.

It may be easier to think in terms of how much total incremental asset return is required to reach the breakeven point (assuming reinvestment into the same asset). With the assumption of taxes increasing to 23.8% and holding, the breakeven point is approximately 77%. To find this number, you first need to start with the ratio of the new tax rate to the old tax rate (23.8%/15% = 58.7% increase). You then divide this number by "1 minus the new tax rate" (1-.238 = .762). 58.7%/.762 = .77 or 77%. It's probably easiest to walk through an example to see the equivalence.

Let's assume you have a taxable gain of $100,000. For simplicity, we'll assume a zero basis and a $100,000 current value, though the math works regardless of what basis you use (could also be a $200,000 basis and $300,000 current asset value, for example). Scenario 1: You sell in 2012, and reinvest the $85,000 in the same asset (setting aside the $15,000 for your tax bill). Scenario 2: You hold on to the entire $100,000. In both scenarios, you eventually sell in the future after an additional 77% appreciation, when taxes are 23.8%. Your future after tax values would be as follows:

Scenario 1: $85,000 * 1.77 = $150,450 future value. Your basis after selling in 2012 and reinvesting is $85,000, so taxable amount is $150,450 - $85,000 = $65,450. Tax of 23.8% on this amount is $15,577, and the future after tax proceeds are therefore $150,450 - $15,577 = **$134,873.**

Scenario 2: $100,000 * 1.77 = $177,000 future value. Your basis is zero, so entire amount is taxable: 23.8% tax = $42,126. Your future after tax proceeds are $177,000 - $42,126 = **$134,874** (small rounding in using exactly 77% results in the $1 mismatch).

If you've gotten this far, you can probably handle the introduction of one last and important modification to this framework. So far, we assume net proceeds (setting aside the amount necessary to pay taxes) from any sale would be reinvested into an asset with the same expected return as what is being sold. This is perfectly acceptable as there is no applicable "wash sale" rule or required holding period when you are triggering a gain - you can buy the same asset back immediately after you've sold it. If it's the case that your asset is either highly concentrated (thus keeping your overall portfolio from being adequately diversified) or you could reinvest in an asset with a superior *Risk Adjusted* Expected Return, the incremental "Opportunity Cost" of not doing this also should be included in the framework.

In other words, if you assumed an expected return of the current asset of 6%, but could reinvest in a different asset with a 7% expected return and similar risk profile, then you should subtract this 1% Opportunity Cost from the 6%, and use 5% in the chart above (resulting in a longer breakeven holding period of 2024).

The main point is that when one holds onto an asset to avoid taxes, there are often other inefficiencies that arise over time that should be considered. A "harvesting gains" approach may provide an opportunity to "right these wrongs" and get a portfolio back track, closer to the efficient frontier (and/or away from a high fee asset manager). At the very least, the upcoming changes in the tax laws should trigger a proactive assessment of your portfolio, balancing liquidity needs with the goal of maximizing *after tax* value.

**Disclosure: **I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.