To Realize, or Not to Realize? Capital Gains Tax and Portfolio Choice

Abstract

The central question addressed in this note is whether it is better to sell (and re-purchase) appreciated assets now and pay today's long-term capital gains tax rate, or wait to realize gains in the future and pay a likely higher capital gains tax rate. The authors argue that a framework based on maximizing expected risk-adjusted wealth should be the preferred method for answering some of the important questions arising from the interaction of taxes and investing. Investment theory holds that in a world of efficient markets, random walks and no taxes, horizon shouldn't materially affect many types of investment decisions. However, as soon as tax enters the picture, horizon in many situations becomes the single most important input an investor needs to think about. For investors with long horizons and moderate-size unrealized capital gains, it will usually make sense to defer realization even if the investor expects the tax rate to jump by 20 percentage points. Surprisingly, at intermediate time horizons, the optimal decision can be to realize some, but not all, of the unrealized gains. Investment horizon isn't the only critical input, and the interaction of all the relevant variables puts the development of a generic rule-of-thumb out of reach.