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In this video we'll talk about a realization-based capital gains tax and

what incentives that gives to taxable investors.

So in the United States, capital gains on assets are only taxed

when the asset is sold, not when the gain occurs.

So that gives a possibility for some tax timing strategies.

You basically control when you will have to pay taxes

when you're investing in assets.

Since 1988, gains realized on assets held for more than a year are often

taxed at a lower rate than gains realized on assets that are held less than a year.

And over time this cutoff has varied.

Sometimes it's been six months, or nine months, but that also suggests some tax

timing strategies, to be sensitive to this long term versus short term cut off.

For example, with the 2003 tax cut,

the tax rate on long-term realized capital gains was lowered to 15%,

while the tax rate on short-term capital gains was at 35%,

which corresponded to the highest tax rate on labor income.

So you could see a big difference, a 35 versus 15 for

short-term gains, gains that are sold within a year

verses long-term gains, stocks that are sold with a capital gain held over a year.

Waiting that little extra to get over that year hump

makes a big difference in terms of the taxes you pay.

So this allows for the potential for

some tax-timing strategies that can boost after-tax returns.

And if you're trading in a taxable account, what you really care about at

the end of the day, are, what are your returns after any taxes are paid.

So let's talk about some tax timing strategies.

I know when you see this 1040, already some anxiety is rushing up in you.

But relax here, I'm actually going to talk about some potential ways

to lower your tax bill with some tax timing strategies,

involves when you sell assets that have appreciated or depreciated in value.

So, let's think about losses versus gains.

Even if the market is efficient and there is no skill in picking stocks,

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you can potentially earn returns through tax-timing strategies.

Okay, so what's an idea?

Realize investments with a loss within a year of purchase, so

that deduction is valued at the marginal ordinary income tax rate.

So for losses, you want to realize them short-term within a year.

So then you'll get the value of that deduction at this high marginal rate.

Which is maybe 35.

Or if you're fortunate enough to be in the highest income tax bracket, 39.6.

Realize investments that have gone up in value, that have a gain.

Realize them at least a year after purchase or more so

that gain is taxed at the reduced long term capital gains tax rate which is, for

a lot of people, 15% or if you're in the highest tax bracket it's 20 plus

a 3.8% Medicare surcharge for a total of 23.8%.

But that 23.8% is significantly lower than the 35 or

39.6% tax rate for short term gains.

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December 31 is an important date to think about when considering tax timing

strategies.

Why?

It's the end of the year for tax purposes in the United States.

So if you realize a gain on December 30 instead of January 2 of the next year,

you're going to have to pay taxes on that gain, a year earlier.

So, just a few days' difference.

December 30th versus January 2nd is enough to push your tax liability up a year.

Okay, now the flip side is,

if you realize a loss on December 30th instead of January 2nd of next year,

you'll get the benefit of the tax deduction of that loss a year earlier.

So, clear incentives realize losses before the end of the tax year,

postpone the realization of gains until the next tax year,

just to delay the payment and accelerate the getting of deductions, here.

And that, we'll talk about this later,

suggests maybe there might be a seasonal pattern.

Sell stocks with losses before the end of the year,

hold on to stocks with gains until after the start of the new year.

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Taxes on labor income, interest income,

dividend income, are taxed on an annual basis when they occur.

Capital gains are taxed on the realization basis.

When you sell the asset, you might think now that, well,

we could monitor people's stock investments.

See if they've gone up during the year.

If they have, assess a tax.

But that's not the way it works.

You only will pay tax when we know for

sure what the gain is, or loss is, when you sell it.

So, that's what we mean by realization base tax.

Okay.

So, you could think about trying to calculate how much are investors saving

by having this realization-based tax as opposed to an annual tax.

And the bottom line is, taxes delayed are always taxes saved.

Now, an interesting calculation would be,

what is this annual equivalent capital gains tax rate that

would be the same to you as an investor as this realization-based tax rate.

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So when we have this effective tax rate that you really pay,

it takes into account the value of the delayed realization of gains.

You don't pay tax when the gain happens,

you only pay tax when you sell and if you postpone selling the asset for

a long time you'll get the benefit of this kind of delayed payment of taxes.

There's also another benefit called Basis step-up at death.

If you inherit an asset that's gone up in value, you don't have to pay capital

gains tax on the gains incurred by the person who gave it to you.

Okay, so that's something very useful to think about as well in terms of

planning what assets to draw down late in life.

So let's go through some examples here of calculating an effective

capital gains tax rate, okay?

And this is a way to tell you what annual tax rate would be equivalent

to the current realization base tax rate that people face.

So as we'll see in the calculations, the longer you hold an asset,

the smaller is this effective capital gains tax rate you pay,

highlighting that taxes deferred are always taxes saved for you.

So let's look at some examples here, to illustrate this.

So let's suppose an asset generates a return of 10% per year.

The asset will be held for ten years.

And the capital gains tax rate upon realization, upon sale.

After ten years, it's 20 percent.

So the question is, what is the effective annual capital gains tax rate?

This bold italicized tax that would make you indifferent between having this

20% tax when you sell it, versus this annual tax rate.

Okay.

So that's why, when I talked about effective capital gains tax rate,

we're solving for this bold, italics tax.

So how do we solve for that?

Well first,

let's look at what is our wealth going to be with a realization base tax.

So we're investing for ten years.

Our return is 10% per year.

That was just an assumption.

So, let's say we just start out with a dollar,

1.1 to the tenth is our wealth after ten years.

We need to figure out the capital gain, so subtract our initial

principle of a dollar, this is our capital gain, right here.

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Multiply that by .8 because we get to keep 80% of the capital gain,

20% is a realization-based capital gains tax.

So this is our after-tax value of the gain.

Add back to that our principle,

that's our wealth after ten years in a realization-based tax scheme.

So let's consider what annual tax rate on our gains gives us the same wealth?

So let's assume we have this r of 10% here, 1 minus the annual tax rate.

So each year, our 10% return, we pay tax on that.

And then this after-tax return is grossed up for 10 years.

So we want to find, what's the annual tax rate that makes the left-hand side and

the right-hand side wealth after ten years the same?

It turns out, that annual tax rate is 14.3%.

So this highlights the advantage of delaying the realization of gains.

Even though the realization-based tax rate is 20%,

that's a tax rate you pay when you sell the stock,

that's equivalent to an annual tax rate of only 14.3%, okay?

So this basically shows you the benefit of deferring the sale of the stock.

Okay? And this was based on the assumption of

a ten year holding period, and 10% return.

Let's consider alternatives, here.

So, let's look.

What if there's a 10% return versus a 20% return and consider different

holding periods to really show how the effective annual capital gains tax rate

you pay can be very low if returns are high and holding periods are low.

So let's look at this here, we're assuming a 20% realization rate.

Your 20% tax you pay when you sell stocks.

And we're going to find,

what's the equivalent annual tax that you would be paying if you're holding it for

10 years, if you're holding it for

20 years, if you're holding it for 30 years, if you're holding it for 40 years.

And now we're going to consider if the asset's going up 10% per year,

the blue line, or 20% per year, the red line.

So the first calculation we did just now, said that if

you have a ten year holding period and the asset's going up 10% per year,

this 20% realization-based capital gains tax, you pay 20% when you sell it,

is equivalent to a 14.3% annual tax rate on gains.

If you go out 20 years, now it's a 10% annual tax rate.

If you go out 40 years, The 20% tax rate when you

sell on the gains is equivalent to a 6% annual tax rate.

So when you hear the capital gains tax rate is 20%,

if you hold the asset a long time, it's effectively much less.

And if you have larger gains per year, 20%.

Now that 20% realization based tax rate Is only 10.9% if you

hold it ten years and sell after that.

6.5% if you hold it 20 years at 20% return per year and sell after that.

And then if you hold it all the way out to 40 years, okay, 40 year investment.

You sell the investment after the 40 years.

You pay 20% Capital gains tax on that.

That is equivalent to only paying a 3% tax rate per year on the gains.

So this really highlights that for

long holding periods you can reduce this effective capital gains tax rate that

you're paying on an annual basis down to a very, very small amount.

It shows the advantage of having a realization based tax as opposed

to the annual tax.

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So what do I mean by this?

And here we're going to unfortunately pick on your long-lost uncle

because unfortunately, this relative has to die.

We don't want to make it a parent or a grandparent or even an aunt.

You might have a sentimental attachment with so-and-so, if someone has to die,

you always kind of pick the example using the uncle, so that's what we'll do here.

Your long-lost uncle has $100,000 in stock and it has a purchase price of $10,000.

If your uncle sells the stock himself, he'll pay tax on the $90,000 gain.

Maybe it's 15%, maybe it's 20%, but we'll pay a long-term capital gains tax.

And I'm assuming you know, held it for over a year.

Now if your uncle dies and bequeaths the stock to you, your basis,

or purchase price, is not the $10,000 your uncle paid.

But it's at $100,000, which is the current value.

That's why it's basis as a purchase price step-up at death.

When the assets pass down to you, your purchase price is not the $10,000,

it's stepped up to $100,000.

So if you sell the stock the day after the uncle dies,

you pay zero capital gains tax.

If the uncle sells the stock the day before he dies He pays tax on 9,000 gain,

100,000 minus 10,000.

So this can dramatically reduce capital gains tax.

If you sell the stock after you inherit it,

you're paying zero capital gains tax on that.

Okay, so what are some key takeaways from this discussion about

capital gains taxes and the incentives it gives for realization patterns?

Capital gains taxes are taxed on a realization basis in the US,

often with lower tax rates for long-term gains then short term gains.

This realization-based tax, along with these different rates for long term versus

short term, allow for tax-timing strategies that can boost returns.

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segment we had in the first course, we'll bring it back for the second course.

So what are some upcoming attractions?

Does this realization-based capital gains tax affect stock returns?

Does it affect the sale decisions of investors?

We'll talk about this later in this module.

Does a realization-based capital gains tax

lead to a seasonal pattern in stock returns?

And does a capital gains tax affect how people trade, sell stocks?

All that will be upcoming in the course.