An investor has a realized capital gain of $100,000 and pays a capital gains tax rate of 20%. The investor is considering selling Stock A to reduce his tax bill. Stock A has a cost basis of $120,000 and has fallen to a current market value of $80,000. Assume the investor can sell Stock A this year and reinvest in a stock with similar return expectations, Stock B. Assume both stocks then double in price and are liquidated next year. Calculate and show your calculations of the total tax bills this year and next for the investor if:
- Stock A is sold next year.
- Stock A is sold this year and the sale proceeds are reinvested in Stock B.
- Stock A is sold this year and the sale proceeds plus year 1 tax savings are reinvested in Stock B.
Answer:
Option 1:
Taxes year 1: $100,000 already realized gain @ 20% = $20,000
Taxes year 2: Projected sale price of A is $80,000 × 2 = $160,000
Less cost basis of $120,000 for gain of $40,000
Tax on sale is $40,000 @ 20% = $8,000
Cumulative tax bill of $28,000.
Option 2:
Taxes year 1: $40,000 tax loss harvest from selling A reduces gain to $60,000 @ 20% = $12,000
Taxes year 2: Sale of Stock A in year 1 generates $80,000 invested in Stock B; Stock B then doubles in value to $160,000 for a taxable gain when Stock B is sold of $80,000 @ 20% = $16,000
Cumulative tax bill of $28,000; $8,000 less in year 1 but $8,000 more in year 2 than Option 1.
Option 3:
Taxes year 1: $40,000 tax loss harvest from selling Stock A reduces gain to $60,000 @ 20% = $12,000
Taxes year 2: sale of Stock A in year 1 generates $80,000 and $8,000 tax savings for $88,000 invested in Stock B; Stock B then doubles in value to $176,000 for a taxable gain when Stock B is sold of $88,000 @ 20% = $17,600
Cumulative tax bill of $29,600; a higher tax bill than Option 2 because more funds were invested in the appreciating Stock B.
I would have 2 questions:
- Option 1: the text says “both stocks double in price” next year. So, in year 2: why do they apply the tax to (120k - 80k)? I would have doubled A to 240k, and substract 120k (cost basis).
- Option 3: why do they apply 0,2 to (2x88k - 88k)? I would have substracted 80k, not 88k… I do understand we invest both proceeds AND tax savings, so B has a value of 88k, and it doubles to 176k. But then why substract 88k and not 80? (the value to which the market value has fallen)
Thanks!