A Gut-Punch Averted
May 18, 2018
Please read the important disclaimers at the bottom of this post. Past performance is not indicative of future results. Not a recommendation to buy or sell securities. Nothing in this presentation is intended to be construed as investment advice.
A Gut-Punch Averted
: The most recent tax reform proposal from Republican leaders in Congress removed the proposed mandate for first-in-first-out (FIFO) accounting of stock transactions. The FIFO mandate, projected to add only $2-3 billion in revenue over 10 years in a bill that would add hundreds of billions to the deficit, would have disproportionately hurt long-term investors and those that add to their investments over time. We had been concerned that passage of such a mandate could cause temporary selling pressure in equity markets, as long-term owners of stock could seek to trim holdings under a more flexible tax structure.
November Market Recap: The S&P 500 posted its 13th consecutive monthly gain with a 3.1% return in November. The 13-month streak is now the longest on record, surpassing 12 months of consecutive gains in 1935-1936. Positive reports to start the holiday shopping season sent retail stocks higher, and financial stocks continue to benefit from the rising rate environment. Fixed income indices posted modest losses, and the US Treasury yield curve continued its flattening trend. A late November meeting between OPEC and Russia caused speculation for further oil output restrictions, sending WTI Crude Oil higher by nearly $3/bbl. to $57.42.
In recent weeks, we prepared to deliver a full-throated warning about a lesser-known provision in the Senate tax reform proposal: the FIFO mandate. However, before we could publish the commentary, the most recent proposal removed the FIFO mandate from its plan. Under current law, investors can choose its specific shares to sell, which helps them manage their tax liability. The bill would have forced investors to use First-In-First-Out (FIFO) accounting for stock transactions.
Despite the many problems still left in the final tax reform proposal, in removing the FIFO provision the GOP got this one right. Many of us were taught from an early age to save as much as possible to begin investing early and to add to our holdings over time, a technique known as dollar-cost-averaging. A FIFO mandate would disproportionately punish long-term investors, particularly those that add to their holdings over time. Including a FIFO mandate would have only raised approximately $2-3 billion in revenue over 10 years. This is a relatively small sum by Washington’s standards, in a bill that is projected to add over $1 trillion cumulatively to the deficit. Perhaps even more egregiously, Congress was prepared to give mutual funds an exemption for trades made inside the fund after the industry successfully lobbied against the mandate.
Assuming an investor doesn’t purchase the entirety of his or her shares at once, for example using dollar-cost-averaging, the investor accumulates shares in lots that each correspond to a specific date, time, and price the shares were purchased. Upon selling some of these shares, investors have the freedom to choose which of the lots they would like to sell. If the investor had only one lot, there is no choice to make. However, if the investor had made more than one purchase and is not closing out the entire position, the investor can choose which lot(s) to sell. The investor must use one of three methods to choose: Last-In-First-Out, in which the latest purchase is liquidated, First-In-First-Out, in which the earliest purchase is liquidated, or specific identification. Mutual fund owners have the average-cost method instead of Last-In-First-Out.
Each of these methods will have a different effect on the investor’s short-term and long-term capital gains taxes. Each investor is different, so there is no single accounting method which can be applied to all investors to minimize their taxes. In a rising market, investors forced to sell will typically choose to sell the highest-cost lots to avoid incurring larger capital gains taxes (usually LIFO). Unless, of course, those lots are less than a year old and the investor has lots that are more than a year old, in which case the investor would choose to sell those lots so they will be taxed at the lower long-term capital gains rate. The investor could use FIFO or specific identification in this case. An investor may want to capture losses in a security, but would want to do so at his or her marginal rate. To do this, the investor would need to use LIFO or specific identification.
Congress’ previously proposed FIFO mandate makes selling a tricky endeavor, particularly for long-term holders/dollar-cost-averagers during a market drawdown. As a thought experiment, we simulated a dollar-cost-averaging strategy that purchased $500/month of the S&P 500 ETF (SPY), from its inception in 1993 until today. Over the period, the hypothetical investor would have acquired approximately 1,444 shares of the ETF, worth $384,900 today, for $150,000. If that investor attempted to sell 100 shares today, which would generate $26,665 in proceeds, a FIFO mandate would cause the investor to generate over $22,000 of taxable gains. A last-in-first-out (LIFO) approach would result in only around $5,000 in taxable gain. Although the tax rate on the $22,000 would be 15%-20% vs the investor’s presumably larger marginal tax rate (25%-39.6%), there is still a much larger amount paid in either case if FIFO were used.