Paul Winkler: So you guys want to talk about that capital gains thing while we’re just sitting here talking? Now I know that there was a question about it.
Evan Barnard: It’s kind of overcast. We can be depressing for people today. Absolutely.
Paul Winkler: No, this is not depressing. No, no, not, not on my watch. Nothing gets depressing.
The Capital Gains Tax Increase
It was Thursday, right? I think it was Thursday. There was an announcement that Biden was going to raise taxes. I just got a kick out of our stream between the various offices: “Oh my goodness. He’s raising. Look at what happened to the stock market. And I’m glad I’m invested.” I think I already said I’m glad you’re invested in international stocks, tongue in cheek, but not tongue in cheek because you know, the reality of it is—
Ira Work: I didn’t mean that tongue in cheek at all.
Paul Winkler: I know you didn’t, that’s what disturbs me.
Ira Work: No, because the U.S. markets went down, but the international markets all went up.
Paul Winkler: I know. Well, they were sorta mixed. Yeah. They were sort of mixed, but you make a good point. I mean, the reality of it is when you invest, you diversify, because you never know what calamity will befall the earth, as Ecclesiastes says. And it might be the calamity is a presidential action.
Evan Barnard: What translation is that out of?
Paul Winkler: This is the new Paul version.
Evan Barnard: The new guru translation of Ecclesiastes.
Paul Winkler: That’s right. In reality, if we look at what happened, it was interesting. Because I made the comment in the post. I said, “Yeah, like this was a big surprise. Like nobody knew he was gonna do this.” Everybody knew he was going to do this.
And matter of fact, there was an article that actually talked about that. “Capital gains tax high: Why did the stock market bounce back so fast?” was the title of the article from The Wall Street Journal. Because it did go down on Thursday a little bit. And it wasn’t even that big of a downturn on Thursday, really, when it got down to a why, because everybody kind of knew this was what he was going to do. But you know, the market comes out and acts like this is a big calamity. Oh my goodness.
We went down less than 1%. So not a big deal, number one. It falls 320 points for the Dow, which is only 0.9%. I mean, for the Dow. And then there are other markets besides the Dow, believe it or not, but that was the one everybody was talking about. And then they’re talking about, well, we could look at 20% capital gains tax rate up to 39.6. And you know, for me, I listen to the talk about that and I wonder: who’s just going to go willingly just start selling property like crazy, knowing that 40% of it would go to the government?
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Why Keep Capital Gains Tax Low
What we know about capital gains tax rates is that they always have been lower for a good reason. And that’s because capital gets tied up if you have too high of a rate. Now part of the reason—there’s a reason, guys, that the capital gains tax rate is actually less than the regular federal income tax rate. There’s a logical reason as well. And part of it is that what actually contributes to capital gains, well, part of it’s just plain old inflation. So you think about it— because of inflation, the value of property goes up simply because the purchasing power of the dollar goes down. To go in and actually tax somebody on something because the dollar is depreciating is—that’s problematic. I mean really, and everybody realizes it. Yeah. For the most part, everyone realizes that.
Evan Barnard: It’s almost immoral.
Paul Winkler: It is, it really is. So, you know, people go, “Oh, it’s just all that . . . ” Well, because a lot of property—and then it gets tied up as well because of the fact that people will sit on property, and it might be a much higher and better use for that property, maybe around the corner, if somebody would get rid of it. But I’ve seen properties—and right around here, where you see it on the corner of this major thoroughfare. And nobody will sell the doggone thing because the tax rates are too high. I remember back in the 1980s, and we had a 28% capital gains tax rate and nobody really wanted to sell stuff. Yeah. Let alone try to go and pop it up to 40%. Now you’re looking at “for real” trouble. So that’s the proposal. I don’t know if you guys have heard that. Some people are saying, “Well, that’s just, he’s kind of throwing out that trial balloon, 40% just to start it at a high level.”
Evan Barnard: Well, I think they’re looking at the top income tax bracket, as well as the Obamacare surtax . And so they get to the 39.6 or whatever.
Paul Winkler: 39.6 plus the surtax. Yes.
Evan Barnard: Frankly, I’m opposed to any tax hikes. So let me start there, but I was kind of surprised that that’s on people that have an earned income above a million dollars. So, I mean, I think that’s one of the other reasons there’s not much of a big hubbub in terms of just the overall market is, frankly based on the campaign, I would have expected a lot more people paying a lot higher capital gains tax than what’s been floated.
Paul Winkler: You think you were thinking 400,000?
Evan Barnard: You know, I figured it’s going to hit somewhere around where you get into the 32%. I’ve lost track of the brackets at this point, but I kind of figured it was going to affect more people to be honest. And so I think it stinks that the people making over a million dollars—you’re going to hit that bracket. But I’m just surprised that that narrow of an increase, which again, I disagree with, creates that much extra revenue for the government. And that’s kind of amazing.
Paul Winkler: Well, we’ve seen this before where the tax projections fall way below. The outcome falls way below the projections. Because what they’re assuming is that behavior doesn’t change. And that’s the problem with these projections is they assume that people will just continue to sell at the same pace that they had been selling before. But what it doesn’t take into account is that tax law changes do affect behavior. And people will sit on property, and there’s a lot of talk, people saying, one of the things that people are thinking about doing is, “Well, hey, if they go and raise these tax rates, what we’re going to do is, these loans that we take out on our portfolio as collateral will become more popular than they are right now.”
How to Prepare for the Increase
That’s something actually that I was talking to a good friend about the other day, and talking about how this is something that we’re actually looking at ourselves. And people are asking, “Paul, what are you guys doing?” Already looked into it. I’ve already looked into it. And we have some really decent ideas as far as where we can get collateralized loans if need be.
Now, I’m hoping we don’t need to do this kind of stuff, but you can actually do that and avoid the taxes because you don’t have to sell if you need access to money. So that’s one of the things that you can do. Another thing you do is use simply one of the things we’ve already done in the portfolios. What we do in our practice is we rebalance using cash flows.
So number one, we don’t go and sell something and buy something else if we don’t have to. We try to do it as much as we possibly can through cash flows. So you’re buying whatever is underrepresented.
So, to give you an example of out there, if you guys are wondering, we’re talking about, let’s say you have 10% of your money in one area of the market and 10% of your money in another area of the market. And one area goes down and it’s only taking up 8%. It’s not doing as well. And the other is taking up 12. It’s done better. So what do we do? Instead of selling the 2% overage on the 12 and buying the 8, which is under by two, and rebalancing that way, thereby taking the capital gain and recognizing it, what we do is we say, “Okay, well, we got new money. I own the same funds as everybody else owns.” And typically funds and ETFs will have net positive cash flows. In other words, more money coming in than going out. So what we do instead is we just redirect the new money into the 8 instead of having to sell the 12. And everybody owns the same portfolio. It’s a mutually funded portfolio, even if it’s an ETF it’s mutually funded. And then what we do is we avoid the taxation. Voila! We’ve got the same result.
The other thing we can do is we can make sure that if new money is flowing into a non-qualified—by the way, this is only affecting non-qualified portfolio right now—something you got to keep in mind if you’re dealing with your IRAs, your 401ks, your Roth IRAs, your 403Bs, 457s, Simples, you know, all of those things, it’s a non-event for that area of the market. And that’s where a ton of money is when it really gets down to it.
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Will the Changes Be Retroactive?
Evan Barnard: Yeah. I think one other thing that—I mean, there’s all kinds of strategies that sometimes you ignore because either maybe the expense of implementing a strategy or the complexity. Sure. I mean, it maybe sounds silly to say, but you’re like, “The tax is only two grand, so I’m just not going to worry about hiring this or that. But now all of a sudden, if that tax is $5,000, now it’s worth doing a little bit of research.” I think we’ll see increased charitable giving of appreciated securities out of a taxable. Where sometimes I don’t want to go to the trouble, now it’s enough of a bite that you go to the trouble.
Paul Winkler: Yeah. And you know, the thing is that you may go through the trouble. Now, the question that people might be asking is, “Do you pull out of the stock market all together as a result of it?” Well, don’t. And why? Because if you think about it, you may have appreciated positions. And you know, the thing is when you sell that, you actually triggered the tax, number one. If you do it before the tax law changes, you might get by with something. But there’s one problem. A lot of times these tax law changes are retroactive.
Ira Work: And that’s what I’m thinking. We don’t know what the date of that tax law change, if it does go through, what it’s going to be. Are they going to retroactive it to January 1, 2021? And then everything that’s been sold, that’s already going to be locked out.
Capital Gains Changes Through History
Paul Winkler: Right. Exactly. The reality of it is if you look at stock market history, and I did this a few weeks ago, we looked at the biggest tax increases in history and went through. I actually had a list of probably the top dozen, the biggest tax law increases in history. And I think I stopped at five because it was becoming redundant. But the reality of it was even with huge tax increases, the markets were pretty positive. In just about every instance, the markets still went up. That’s the same thing with capital gains tax rates. You have increases back through history and you look at them.
I think, as I recall looking at the data, I think there were four big capital gains tax rate increases. Two of them, the market went up. Two of them, the market went down. But what coincided when the years when the market went down was that the economy was extremely weak. There were other factors that actually drove the stock market down in those two instances that I looked at. So in reality, it’s not something that we go and think, “Oh my goodness, this could ruin the stock market,” number one.
But number two, the other thing is this—you’ll also look at it and go, if all of a sudden we stymie the U.S. economy because we go and lock up money and capital gains increases and all of that, well, what benefit does that maybe have in international markets that aren’t going to be subject to the same rules or people that are investors in other markets around the world? They may go, “Oh, hallelujah, look at that. They locked up U.S. assets for a while by raising the tax rates. And we’re going to benefit from this.” So, you know, there are a lot of other things that we have to think about.
Evan Barnard: And we’re even really having the conversation around it from a portfolio structure and management standpoint for the investor. Corporations are also going to look at all of this and all of a sudden, if they say, “Okay, well, you know, dividends and capital gains are really coming out of the same bucket. They’re just taxed differently.” So if all of a sudden gains go up to 40%, a company may increase its dividend. And so now it’s a qualified dividend back to 15 or something. The investors are looking at it from one side. Corporations are looking at it from another standpoint. And I mean, that’s what makes the market work. That’s a miracle.
Paul Winkler: Yeah. You say that it’s a really good point because you look back through history, and we did historically have much higher dividend rates in the past than we have now. But when things changed, the reality of it is that having a higher dividend didn’t make as much sense because of the double taxation of the dividend, that they didn’t want to necessarily do that. So that is a really good point, number one.
The Senate Will Be the Deciding Factor
Number two—well, this is probably our number eight now, point number eight. But this is all assuming that the Senate goes along with all this, right? Because we have a 50–50 Senate, and there are a lot of people on both sides of the aisle and on the Democratic side of the aisle, they’re going, “I don’t think this is a really good idea. My seat isn’t necessarily all that secure. And I don’t want to be the one that is responsible as one of the deciding votes for a large increase in taxes, which ruins jobs or causes some financial disruption.” So I think there are a lot of things to point out.
Ira Work: I would also think because some of the senators are probably a lot more mature than a lot of the people in their house, a lot of them are probably sitting with some hefty portfolios that they too do not want to take capital gains on.
Paul Winkler: Good point, Ira. Yeah, absolutely. They’re affected as well. And that’s what makes it interesting because they’re talking about getting rid of the step-up in basis. And I think, wow, what an interesting situation that would be, to try to get rid of the step-up in basis. Because you could have people with family businesses, and there’s nobody in the family that necessarily wants to keep the business. So you go, “Okay, so we’re going to force them to sell the business at the person’s death.” They don’t have the assets because the assets are locked up in the business itself. And then what does the family do to pay the taxes, if they have to sell this thing and there’s no step up in basis?
And that could ruin a lot of small businesses. I mean, there’s just a lot of implications that need to be thought through. So I don’t think it’s a foregone conclusion by any stretch of the imagination that they’re going to go and make this kind of a change without a very pretty big fight on their hands.
Evan Barnard:
Yeah. And culturally, regardless of how you think, how you perceive the events of January 6th and the calamity there in D.C.—I think even culturally, when we start to have some of these tax issues being debated, I think Congress is at least way more aware than they might’ve been a year or two ago that they can only push the American people so far. Especially if you are a Democrat or Republican from a swing state or whatever you want to call it, you know, they’re, I think they’ve at least been put on notice that they’re not immune to going over the line.
And, you know, I think that colors things like these debates of, “Okay, well, how many percentage do we really want to go? Because we don’t want to be, you know, ducking out of our car to get into the office every day.”
Be Prepared, But Don’t Panic
Paul Winkler: And you know, a lot of people are looking around going, “You know what, I’m sick and tired of being cooped up. I’m looking forward to this 1920s type of a . . . people actually getting out and doing things and the economy getting better. And you know, just that whole thing is important to a lot of people. And so I think that there are a lot of factors that tell us a) we don’t go and make knee-jerk reactions and go change things overnight.
Are there things that we have in the back of our mind that we could do in case it does happen? Are there strategies that we could be using? Absolutely, no question about it. And many of them we’re already using simply because we try to avoid taxes anyway, capital gains taxes anyway, in the management of a portfolio.
So there are a lot of things that we’ve done over the years to actually reduce and mitigate some of those taxes in the first place. So do we want to be reactive like that? No, but are we going to be cognizant of the fact that there may be changes in Washington and we have to respond to them? Absolutely. And there are things that we can do. And the reality of it is there are things that can be done. And the reality of it is that there are some serious repercussions when taxes are increased in this way.
So it’s not something that necessarily is going to be taken lightly, especially when you have such a narrow—well, I say “narrow” margin over in the Senate, but it’s really 50–50. It’s only a narrow margin because the vice-president can vote and push things over one way or another, but you have enough Democrats on the other side that don’t necessarily want this, that I’m not in panic mode by any stretch of the imagination regarding capital gains tax increases or anything like that at this time.
Paul Winkler Investor Coaching Show, along with Evan Barnard and Ira Work. We’ll be back right after this. Stay tuned.
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