By
Luke
Nagell
:
The election results are in and as expected Congress and the
White House maintain status quo. As a result, certain tax codes
like the capital gains and dividend and interest income tax rates
are at risk of a significant increase. Of the two tax codes, the
capital gains tax rate change will have the biggest impact on
prices of stocks, bonds, housing, and any business venture that has
been successful over recent years. As the law currently stands, the
capital gains tax rate will see the largest year-over-year increase
in history. Some intelligent investors didn't wait for election
results to lock in the low capital gains tax rate.
A g ood example is Star Wars creator George Lucas, who recently
sold his Lucas Films empire to Disney (
DIS
) for $4.05 billion. Lucas built his empire over many years and is
sitting on a very large capital gain. Although Lucas has not
publicly stated that tax policies had anything to do with the
timing of the sale, th ere is speculation that it was a large
factor. If outcomes from past tax policy changes are any indication
of what will result this time around, then be prepared for a lot
more selling between now and year-end.
In 1986, the maximum tax rate on long-term capital gains
increased from 20% to 28%, a 40% increase. This was the largest
year-over-year capital gains tax rate increase from 1954 through
1986 and remains the largest increase unless the rate goes up as it
is currently written. As the law stands, the capital gains tax rate
would increase from 15% to 25% which results in a 67% increase. The
increase encompasses expiration of a 5% Bush-era tax cut,
expiration of a 1.2% tax deduction nicknamed "Pease" after the
congressman who introduced it, and the implementation of a 3.8%
health reform tax. This is the worst case scenario and this outcome
has a high probability of occurring. Even if the worst case
scenario is avoided, the best case scenario would result in a rate
increase by 25% from a rate of 15% to 18.8%, which only accounts
for the health reform increase.
(click to enlarge)
A look into the tax revenue section for total realized capital
gains in 1986 shows a significant correlation between the increase
in the capital gains tax rate and realization of capital gains. In
the chart below, you can see that in 1986, to tal realized capital
gains as a percent of GDP (green line) increased to 7.35% when the
maximum tax rate on long-ter m capital gains (blue line) went up in
1987. This compares to a 30-year average of 2.65% from 1955 to
1985.
(click to enlarge)
Digging into the 1986 capital gains sales further, you can see
from the chart below that the majority of the capital gains that
were realized in 1986 came from sales in December.
(click to enlarge)
High-income earners will absorb the brunt of the capital gains
tax rate increase. First, the health reform tax and the Pease
deduction only apply to high-income earners. In addition, while
most U.S. citizens receive close to 100% of their income from
salary and wages, the top 400 income earners in the U.S. receive
the majority of their income from capital gains. In fact, in 2007
only 7% of the top 400 tax filers' income in the U.S. came from
salary and wages while 66% came from capital gains. One area that
should be closely watched is the hedge fund industry. For starters,
only accredited investors, defined as having a net worth of $1
million or income exceeding $200,000 in each of two most recent
years, can invest in a hedge fund. Now that we've segmented the
market, w e need to look at the holdings of the hedge funds. It
helps to look at stocks that have had a big run up in the past few
years. As you read this on your iPad, MacBook, or iPhone, one stock
may come to mind.
Apple Inc. (
AAPL
) has seen a more than two-fold increase in price over the past
five years which makes for some nice long-te rm capital gains.
According to Hedge Fund Wisdom, a quarterly hedge fund activity
report from
marketfolly.com
, Apple is held in 17 out of 25 widely followed hedge funds and is
the top holding for six funds. In addition, since Apple is such a
large component of many stock indices, lo ok for the sell-off to
influence the performance of many widely tracked benchmarks.
For example, the Technology Sector ETF (
XLK
) is comprised of 18.5% Apple stock, co mpared to its next largest
holding, International Business Machines (
IBM
) which comprises a modest 8.1%. More importantly, Apple is the
highest weighted stock in both the S&P 500 Index (
SPY
) and the NASDAQ Composite Index (QQQ) and could drag down both
indexes through the end of the year.
Many factors point to selling assets that have seen a
significant run up in price over the past few years. When selling
an empire like Lucas did, it takes an army of legal and financial
experts hundreds of man-hours to complete, whic h results in a very
large transaction cost. Selling marketable securities on a liquid
exchange has minimal transaction fees and can be conducted in your
bath robe in the time it takes to brew a pot of coffee. The
risk-reward is extremely high, especially for a high income
investor. The risk is being in cash while the market rallies into
the end of the year while the reward is avoiding a sell-off and
locking in a low capital gains tax rate for any investors with
unqualified investments. In December of 1986, the S&P 500 Index
was down 2.83% and in January of 1987 it was up 13.18%. Invest like
a Jedi and may the Force be with you.
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.
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