The U.S. presidential election is almost upon us, and many expect capital gains tax rates to increase no matter which candidate wins. Democratic candidate Obama has declared that he wants the capital gains tax rate raised to 20 percent from its current level of 15 percent. If the Republicans win, it is believed that they will not have enough votes to stop the automatic 2010 rollback of the Bush tax cuts. A consensus seems to building that investors should rush out and take gains right now to take advantage of the lower rate. At Twenty-First Securities, we believe investors should do nothing this year and only sell next year if they know they will definitely sell sometime over the next few years. The principles on which this advice is based also apply to non-U.S. investors who are facing the possibility of future increases in capital gains tax rates.

There should be no rush to sell now, certainly not before the election results are in. So, what about next year? If the Democrats win, the inauguration does not take place until mid-January, and after that, Congress will need to debate the merits and pass a bill to institute higher rates. Historically, anytime there has been a change in capital gains rates, the date for the change has never been applied retrospectively. If this trend holds true, investors will have full warning when the change will take place. This advance warning also helps the government raise revenues because an impending increase in capital gains rates is usually accompanied by an out-sized amount of selling to “take advantage” of the lower rate still in effect (but about to be eliminated).

I say “take advantage” cautiously because investors may not be better off using this strategy. Certainly, if the investor knows that he or she will be selling in the next few years, the strategy can make sense. But to a long-term holder, the benefits are less certain. It is important to remember that individual investors in the United States are forgiven capital gains taxes at death through a step-up in basis. Even investors planning on holding investments nine years or more should consider that another administration will be in place by then with its own ideas about tax rates (and the possibility that rates will come back down).

If a sale is to be made today, investors need to consider the “costs” as well. As an example, is a 20 percent tax paid in 2013 actually worse than a 15 percent tax paid in 2008? Investors who sell today will deplete the amount of money available for investing. If they hold off paying the tax, those tax dollars could still be at work in the markets. What rate of return would make an investor indifferent to paying the capital gains tax at the current rates, versus the higher possible capital gains rates in the future?

Table 1 shows the rate of return that needs to be earned when making the pay-now-or-later decision, assuming the current tax rate on capital gains is 15 percent.

Table 1. Breakeven Rates of Return

Note: The current tax rate on capital gains is assumed to be 15 percent.

For example, as Table 1 shows, an investor would need to earn more than 2.069 percent annually over the next 10 years to make paying a 20 percent tax in 2018 preferable to paying a 15 percent tax in 2008. 

Investors are right to be on the alert for higher capital gains taxes, but immediate action is imprudent. We advise waiting to see how the election goes before any action is taken. If Democratic candidate Obama wins, we predict that a 1 July 2009 effective date is the earliest we would see a higher rate. If Republican candidate McCain wins, investors can wait even longer to see how this plays out. For investors with long time horizons, it may be best to keep informed but do nothing even if capital gains rates are scheduled to increase.

Robert N. Gordon is president of Twenty-First Securities.