Optimal Liquidation of Assets in the Presence of Personal Taxes: Implications for Asset Pricing

Abstract

WITH A TAX on realized capital gains, investors realize capital losses and defer capital gains. However, if individuals realize capital gains to consume or for other reasons (such as a cash stock merger) they may defer capital gains tax payments by hedging. The hedge produces a capital loss in one tax year and an equal capital gain in the next tax year. If the hedge is operational, capital gains tax is deferred until death and the capital gains tax is avoided entirely.' With this idealized hedge, the effective marginal tax rate on both short-term and long-term capital gains and losses is zero. Also, investors are indifferent to changes in the actual capital gains rate. Call options and commodity futures contracts are used to construct these hedges. Without transactions costs (no bid-ask spreads and brokerage commission fees),, perfect hedges can indeed be constructed and used to defer capital gains tax, despite IRS regulations designed to discourage their use. Transactions costs may dissipate the hedge's tax benefits, and therefore hedges reduce, but do not eliminate, the capital gains tax's effect on consumption and investment. The loophole in the tax code which enables tax deferral, at least in the absence of transactions costs, arises from the institutional structure of both the options exchange and the commodity futures exchange. A contract writer is not matched with a particular contract buyer. For example, if a call price falls, the call buyer can sell the call, realize a capital loss, and immediately buy a new call. The call writer is not forced to realize a corresponding capital gain. There is a net tax gain at the government's expense. Note that the net tax gain would be zero if the buyer and writer were matched. A tax gain for the buyer would be canceled by a tax loss for the writer. With a blunted but not eliminated capital gains tax, the capital gains tax's effect on optimal investor behavior is quite complex. Under the simplifying assumption that short-term and long-term rates on capital gains and losses are equal, the optimal liquidation policy is to realize capital losses and defer capital gains. With this lock-in effect, it is important to study welfare effects of given