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Implementing Capital Gains Indexing May Need Divine Help

Posted on Aug. 16, 2019

While debate continues over whether the Trump administration can index capital gains through the regulatory process, former government lawyers who worked on similar proposals in the past are sounding the alarm on implementing it.

“If the Treasury Office of Tax Policy is assigned this task, God help them,” Dana L. Trier of Davis, Polk & Wardwell LLP told Tax Notes.

Treasury lawyers under former Presidents Ronald Reagan and George H.W. Bush went through the exercise of examining how capital gains indexing would work in practice after Congress first considered the issue more than 30 years ago. They said that as they dug deeper into the process, it just became more daunting.

“There was no tax lawyer involved in this study that I knew who had any confidence we could make it work in a reasonable manner,” said Trier, Treasury’s tax legislative counsel and acting deputy assistant secretary for tax policy from 1988-1989. Trier said that from the perspective of his roles at Treasury, the whole issue of making capital gains indexing work became a staff morale problem.

The idea of indexing capital gains for inflation has been floated by the Trump administration. The focus so far has been on whether Treasury can enact the change via executive action. Recently, Republican senators sent Treasury a letter urging it to index capital gains because it would juice the economy.

Democrats countered that the plan would cost in excess of $100 billion and would benefit the rich, not working-class Americans. One senator has already promised litigation if the Trump administration goes forward with it.

Indexing would increase a taxpayer’s cost basis in property over time to reflect inflation. For example, say an individual buys stock for $100 in 1985 and sells it for $400 in 2019. That taxpayer would typically pay lower capital gains rates on the difference between the $100 cost basis and the $400 purchase price.

But if the cost basis were indexed for inflation, the cost basis of $100 from 34 years ago could be $250 in 2019 dollars, according to the Bureau of Labor Statisticscalculator. So when the stock is eventually sold in 2019, there would only be $150 of gain to tax once the basis is stepped up.

Even for those like Trier who aren’t outright opposed to the idea of indexing, the practical effects are daunting.

Steven M. Rosenthal of the Urban-Brookings Tax Policy Center is a former attorney with the Joint Committee on Taxation who drafted a legislative proposal in the 1990s at the request of then-House Ways and Means Committee Chair Bill Archer. He said trying to pinpoint all the issues involved with indexing was a heavy lift.

“What if someone holds stock but then hedges that stock by buying a put?” Rosenthal said. “Are you going to allow the cost basis in the stock to be indexed when the downside is protected?”

Rosenthal said that because he was drafting legislation, he had more flexibility when trying to answer those questions. Even if it’s assumed Treasury has the authority to index capital gains, they might not have enough latitude, he said.

“Would they be required to index for all purposes of the code, and for both stocks and depreciable property?” Rosenthal asked. “Could Treasury deny indexing for debt-financed property?”

Lifting the Hood

The easy capital gains indexing example involved the purchase of an asset and its later sale at an overstated gain, but what’s less intuitive is what happens when indexing an asset that’s later sold results in a loss, former Treasury attorney Reed Shuldiner said.

For example, a taxpayer could have $10,000 of gain pre-indexing and then only have $4,000 of taxable gain after indexing for inflation, said Shuldiner, a law professor at the University of Pennsylvania Law School. But if the nominal gain pre-indexing would be zero, the taxpayer would end up with a $6,000 loss.

“One of the decisions is whether to give that taxpayer a loss,” Shuldiner said. “The right answer is yes, you should,” he said, but added that when Congress considered legislation on indexing in the past, it didn’t allow for losses in that scenario.

Shuldiner said some people assume that indexing is only an issue when assets qualify for long-term capital gain treatment because they’ve been held for more than a year, but actually the opposite is true.

For example, consider one person who buys stock, holds it for 10 years, and then sells it for a nominal gain. That gain could actually be caused by inflation, Shuldiner said.

However, another person could trade stock every day for 10 years. The amount of inflation on the stock would be a de minimis amount because the stock was only held for, say, two days, and then sold. Even though the person sold often, over the 10-year period their income would be inaccurately measured just like the person who had held the stock for 10 years, he said.

If the two people are compared, the person holding the stock got the benefit of the preferential capital gain rate and deferral, while the person who was constantly trading paid tax annually on that income and at ordinary rates, Shuldiner said.

“If you ask who is being more overtaxed in this situation, it’s the person who was trading constantly,” Shuldiner said. “When you look at proposals in the past, [indexing] only applied to long-term holdings.”

Reporting Issues

One issue that frequently arises in implementing the indexing regime is what to do with regulated investment companies.

If someone held a mutual fund for 20 years, with quarterly reinvestments of dividends and no other transactions during that 20-year period, they’ll have 81 separate purchases including their original mutual fund purchase, Shuldiner said.

All of that would need to be indexed. Indexing on a prospective basis could be pushed onto the brokers of the mutual fund, just like the basis reporting requirements, Shuldiner said. But for the old assets, it’s much more complex.

And for most business owners, the treatment of depreciation recapture would need to be addressed.

If a taxpayer buys an asset for $1,000 and uses bonus depreciation to write off the full cost in the first year, and that asset is sold in five years for $1,500, the taxpayer is required to recapture the $1,000 in depreciation as ordinary income.

But with indexing, the recapture amount should be the $1,000 bonus depreciation indexed for inflation over the five-year interim period, Shuldiner said. For example, with 3 percent inflation, the recapture amount would be about $1,160, he added.

The taxpayer wouldn’t be thrilled to hear that result, but it could be the right outcome, he said.

So even if the Trump administration prevails on the legality of indexing via regulation, the hard work may be ahead.

“As a Republican tax policy person, I am naturally sympathetic to the objectives of indexing, but I became deeply skeptical of its workability,” Trier said.

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