Originally Posted by stevea
A higher cap-gain rate can change expectation value of a good investment with a positive return into a loser with a negative return.
No it can't. you don't pay capital gains on negative return, in fact you receive deduction you can use against future taxes.
Well you read the words, but clearly you don't understand investment analysis.
Allow me to create a simplistic example that will avoid the complex notation and discussion of probability distributions. Imagine an investment where there is (a priori) a 42% probability of complete loss of investment and a 58% probability of doubling the investment. It *sounds* great but ....
Case 1/ Pretax.
For every dollar invested there is a 42% chance of losing $1, and a 58% chance of gaining $1. Therefore the expectation value of the return on the investment is
0.42*(-1) + 0.58*(+1) = 0.16. You expect a 16% return on average, before considering tax. Fabulous return.
Case 2/ 15% CG rate on gains
If a 15% LTCG rate applies then the return applies, that the expectation value (I'm ignoring the loss tax reduction, will discuss later) then the expectation value of return is
0.42*(-1) + 0.58*(+1)*0.85 = 0.073 or 7.3%. Still a decent return.
Case 3/ 35% CG rate on gains.
If a 35% tax rate applies then ... 0.42*(-1) + 0.58*(+1)*0.65 = -0.043, a 4.3% percent loss !! No one in this tax rate would touch this investment. It needs to at least exceed other safer investments. It's a clear loser.
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You're statement
you don't pay capital gains on negative return, in fact you receive deduction you can use against future taxes.
Is wrong, but we must consider tax treatement of the losses.
Of course there is no CapGain tax on any net loss. No one suggested otherwise.
NO the treatment of Capital Loss is NOT a DEDUCTION. Deductions are from schedule A and calculated after AGI. Cap Gains and accepted losses are adjustment to AGI, part of income.. This has an important impact on AMT calculation.
Cap gains and losses (ST & LT separately) can cancel each other in the year realized. ST Gains are taxed at the normal tax rate. LT Gains are currently taxed at 15%.
Net ST Losses are combined with net LT losses and can only be applied at $3k/yr ($1.5k.or MFS status) as net loss.
The remaining losses have complex treatment for carryover.. There is a one year ST-Loss carry over possible, however it's dependent on other factors such he amounts of realized LT gains and ... well it's very dicey to arrange. You are likely to lose any ST loss not applied in the year realized. The LT-loss is clearer. You can carry over the entire amount and reduce your LT gains realized in future years to the (net of all CGs) limit of the $3k ($1.5k) limit.
The ST strategy is this; if you have a pending ST Loss and you don't have an ST Gain to realize in the same year, then you may be better off holding the equity for the full year to create an LT loss (instead of an ST loss). This means loss of the use of remaining equity and the risk of further declines. So this can be costly but perhaps better than losing the tax advantage.
The LTC-loss strategy is to apply that loss as quickly as possible. $3k/yr isn't much help, you need to create an offsetting LTCG. Every year is sits on your books is an opportunity loss. Most people in higher tax brackets already manage investments to reduce or delay CG realization. so you already MAY have some stock position with a realizible gain. The problem is that if you like the investment you have to sell, and avoid the wash sale tax rule. There are ways to get past this - but they are complex and ugly.
IOW you have to shuffle your portfolio needlessly to reduce taxes (apply the loss).
The real headache comes in down years like 1986 or 2008 were many investor need to re-arrange portfolios and have to realize losses. And also they are unlikely to have much gains sitting around to offset these. In such a case you'll likely to lose most of the ST losses have to carry forward the loss for many years, losing money every year.
Somewhere about a decade ago I read a statistic that well over half of capital losses are never applied to taxes. It's easy to imagine. Many ST losses that can't be applied in the year realized are lost. LT losses that occur late in one's investment career or lifecycle may never be applied. There is also the matter of marginal tax rate in the year the loss is applied. I know I had some LT losses in a year when the rate was 28% and I had to apply these in later years when the rate was 15%. That's a big reduction in CG loss value.
So let's be generous and assume that the investor in case 3/ (high CG rate) can apply half the loss effectively.
Case 4/ 35% CG rate on gains, half of loss applicable to (17.5%effective loss rate).
then ... 0.42*(-1)*(0.825) + 0.58*(+1)*0.65 = -0.0305, lose 3.05% another clear loser.
Sorry - CG tax rates (and carry over rules) have a great impact on investment outcome.
These complex tax rules are mostly pointless and distort markets and make rational
investment unreasonably difficult.
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Buffet can claim that investors don't care about taxes all he likes. No serious investor believes it. It's demagoguery for the ignorami.
