Don't Let Taxes Scare You Into Holding Onto Duds

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Includes: AAPL, GE, PG
by: Eric Butz

Summary

Investors sitting on large capital gains may not sell weak companies due to the large tax cost.

Investors should focus on finding the best investments as the tax cost can be eliminated with a better return.

Ultimately the tax will be paid, so don't forgo better investments simply to defer taxes.

Introduction

I was thinking about Procter & Gamble (NYSE:PG) recently and naturally checked for analysis from Seeking Alpha. No Guilt wrote an article: Procter & Gamble: Dead Money that resonated with my view on P&G. However, I was skeptical about one aspect of the article also discussed in the comments which was the belief that sitting on large unrealized capital gains made holding an equity (P&G in this case) preferable to selling it even if expected subsequent growth was modest, flat or even possibly negative.

As an accountant I often encounter clients who loathe paying taxes, so much so that they will make financial decisions purely on the tax consequences regardless of whether it makes sense; the myth of Homo Economicus is dispelled daily at our office. So reading comments from readers that won't sell because they have owned P&G for 'decades' and don't want to pay the tax made me curious as to whether they were being tax smart or investing dumb.

The same situation will apply to other once high-flying stocks such as Apple (NASDAQ:AAPL) or long-time Blue Chips like General Electric (NYSE:GE).

This analysis quickly determines that holding on to a weak stock for fear of taxes is indeed irrational if there are better opportunities available.

Assumptions

Key to this analysis are just a few variables for calculating a five-year return variance on a long-held stock vs. a new stock.

The primary variable is the tax rate. I assume a long-term capital gains tax rate of 28.6% which is the US average top marginal rate. This rate is higher than what a median income individual or a typical retiree would pay but is reasonable for our analysis. The rates vary from state to state, an individual that earned $1 million in California will pay 33.3% tax on their long-term capital gains while a retiree in Connecticut with total income under $200k will pay a combined 26% tax rate just to pick two states arbitrarily. Using the average top marginal tax rate is more conservative than using a lower number that would better reflect the average tax rates of Seeking Alpha readers.

I provide three scenarios comparing the net after-tax portfolio balances of two hypothetical stocks (Old and New) using the same rate of return (8% & 8%), high differential rate of return (2% & 8%), and a break-even differential rate of return (3.5% & 5%).

For the old stock, or original stock, I assume the tax cost is zero for simplicity such that the market value of the stock is equal to the capital gain upon selling it. You'd get pretty close to this if you purchased P&G in 1980 for $2 (adjusted for splits) and sold it today for $82 since 98% of your proceeds would be taxable.

The dividend is assumed to be included in the total rate of return used for the analysis.

Rationale for Holding On

The thinking behind an investor holding onto a stock with large capital gains is: "if I sell my P&G stock now I will pay many thousands of dollars in tax but I don't think this stock will go down and I'll still get my dividend so why should I pay all that tax?" The reason why it could make sense to pay that tax is if you have other investment opportunities that will yield a better return and surprisingly it doesn't take a large differential in the returns to make switching your investment a good decision. The biggest factor overlooked in this scenario is that eventually you will have to sell your investment and pay tax on the gain.

Scenario 1 - Meet the New Stock, Same as the Old Stock

In the first scenario the new stock and the original stock both return 8% a year after the hypothetical switch in year 0. The original stock ends up with a larger after-tax net value at year 5 which is exactly as expected. The returns were the same but because you sold the stock your return was earned on a smaller investment resulting in a lower overall investment value.

Scenario 2 - New IS Better Than Old

The second scenario is what we'd hope to see. You sell your old, highly profitable but tired P&G and buy a company you've researched after first discovering here on Seeking Alpha and the return is a much higher 8% than the 2% net return from P&G.

Scenario 3 - Break-even at 5% vs. 3.5%

Scenario three finds that the new stock need only have a return 30% higher than the original stock in order to have an ultimate after-tax net value comparable at year 5. Nothing gained nothing lost. This of course assumes that you ultimately sell the original stock and incur tax on the resulting capital gain. If you're able to transfer the equity on a tax-free basis (e.g. at death) then you would be better off holding onto the stock, assuming a small differential between its return and the expected return on your other investment opportunities.

Conclusion

Ultimately the tax man will get his pound of flesh but don't let the fear of a large tax bill prevent you from making better investments.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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