A provision of the Senate
tax bill under debate would negatively impact capital gains taxes for some investors, and could have other wide-ranging effects on financial advisers and their clients, ranging from
charitable giving to tax-loss harvesting.
The bill would require investors to sell stock held in a taxable brokerage account on a "first-in, first-out" basis, meaning investors would need to sell the oldest shares of a company's stock ahead of more recently purchased shares of the same company.
Since the oldest positions tend to have the most appreciation over the long term, selling them first would automatically generate a bigger tax hit than if an investor sold newer shares with less growth. Investors currently have a choice.
Advisers say the so-called FIFO provision wouldn't harm most low- and middle-income taxpayers, who invest minimally in brokerage accounts and pay the lowest capital-gains tax rates. However, the rule could harm many wealthy clients, particularly buy-and-hold investors and those with highly concentrated stock positions.
"I have a lot of clients it'll never affect, because they have 90% of their wealth tied up in retirement accounts," said Jeffrey Levine, CEO and director of
financial planning at
Blueprint Wealth Alliance. "But there are certainly a handful of clients — the upper echelon who've saved significantly in taxable brokerage accounts — that are really going to see the impact."
Here's an
example from the Tax Foundation that quantifies FIFO's potential monetary impact: Suppose an investor bought 100 shares of the XYZ Company at $25 a share in 1990, another 100 shares of XYZ at $50 a share in 2005, and wants to sell 100 shares of XYZ at the current price of $100.
Current law allows the investor to sell the second tranche, for a $5,000 gain. But the FIFO rule would require the investor to sell the first tranche, for a $7,500 gain. The wealthiest investors would pay a 20% tax on the gain.
As a result, clients may be forced to draw down their portfolios more quickly in order to cover the larger tax bill, Mr. Levine said.
The FIFO provision could also impact charitable donations made with stock, either directly or through a donor-advised fund, said Tim Steffen, director of advanced planning in
Robert W. Baird & Co.'s private wealth management group.
Typically, investors donate stock with the lowest cost basis, or those with the greatest appreciation. The investor (and charity) does not have to pay tax on the capital gain, so an investor is able to offload the stock with the biggest tax liability from the portfolio. But that would change under FIFO.
"You'd still get the same charitable-contribution deduction, but you'd be avoiding less gain than you maybe would have otherwise wanted to," Mr. Steffen said.
Opportunities?
The change, though, could open up additional planning strategies for advisers, Mr. Steffen said.
For example, investors typically concentrate their charitable giving at year end, but they could be better off if they did it earlier in the year under a FIFO regime, he said. In this scenario, if investors donated their highest appreciated shares of Apple stock first, then sold less-appreciated Apple shares afterwards it could reduce their capital-gains tax. If reversed, an investor's tax liability would be greater.
In another example, an investor could potentially hold two accounts — one with highly appreciated shares, the other with less-appreciated ones — as a way to circumvent FIFO rules. It's unclear, however, whether that would ultimately be allowed, Mr. Steffen said.
Under FIFO, tax-loss harvesting also would change.
The practice of selling a security that has had a loss by realizing the loss to offset gains of another stock could become "a lot more expensive and difficult" for clients if FIFO is part of the final tax bill, Mr. Levine said.
Current rules allow taxpayers to
offset capital gains with capital losses, dollar for dollar. Advisers can do this using any positions in a taxable portfolio.
However, a situation could arise under FIFO in which an investor's shares of Apple purchased 10 years ago are at a gain, while ones purchased two years ago are at a loss. This investor wouldn't be able to access the shares that have lost value in order to offset a gain elsewhere in the portfolio.
Some robo-advisers such as
Betterment that do tax-loss harvesting for retail clients would have to rejig their programs to account for the new rule.
Republicans on
Wednesday signaled that they had reached an agreement to reconcile the tax legislation passed in the House and Senate, which differ in a few key areas. The House tax bill didn't include the FIFO provision, for example, and it's unclear whether the final bill, which Republicans hope to vote on as early as next week, includes the provision.
If it does, it could rankle House Republicans, more than 40 of whom addressed a letter on Dec. 6 to congressional leaders expressing their strong objection to the FIFO provision.
