Taxing Losers

Abstract

The U.S. tax system, like most in the world, benefits capital gains in two ways. Investors can defer paying tax until they “realize” any gain (typically by sale) rather than when the gain simply occurs via rising prices. Additionally, individual investors pay a lower, preferred rate on their longterm capital gains as compared to their other ordinary income (such as compensation or business profits). However, investors face a burden with respect to their capital losses. Rather than allowing for unlimited capital loss deductions, the Code largely forces investors to match their capital losses against their capital gains. Limits on capital losses could be justified in several ways. The most prominent justification holds that taxpayers should not be able to “cherry pick” loss elements out of an overall winning portfolio. This Article seeks to clarify the nature of the cherrypicking argument. It drops “cherry picking” in favor of the somewhat more descriptive “loss harvesting” used in wealth management literature. We will imagine a world in which Congress does not force taxpayers to match losses against gains. In this world, taxpayers could harvest isolated losses whenever they arise and enjoy the benefits of loss deductions—even if the taxpayer has an overall winning portfolio. Using insights from option theory, we can estimate the cost of aggressive loss harvesting.Forced matching of losses against gains is the primary way the Code curtails loss harvesting. However, forced matching comes at a cost, as it will deny loss deductions to investors who have suffered true losses. Again, option theory gives us a method for estimating these costs and—more importantly—comparing them to the costs of loss harvesting. Based on this comparison, we will see that the “cure” of forced matching may be worse than the “disease” of loss harvesting.