The Senate Finance Committee has decided that a little-known provision that would change tax rules on certain securities sales shouldn't apply to mutual-fund firms. Even so, it would still apply to individual investors.
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The provision would prevent investors from minimizing taxes, when they sell part of a position, by choosing the specific shares being sold. Instead, investors would have to sell their oldest shares first.
As first proposed, the change would have applied to fund companies as well as individuals.
But senators exempted fund firms after some of the largest ones, including Vanguard Group and Eaton Vance Corp., protested by saying the proposed change would tie their portfolio managers' hands, make markets less efficient, and raise taxes on investors.
If the change is enacted for individual investors, "it will take tax planning out of the hands of investors and advisers, and it could make them less inclined to sell," says Tim Steffen, director of advanced planning with Robert W. Baird & Co.
It would also affect firms like Parametric Portfolio Associates, a unit of Eaton Vance, and online financial advisers Betterment LLC, and Wealthfront Inc. These firms offer computerized tax-efficient investing strategies to individuals that typically use sales of specific groups of shares, or lots, to help boost after-tax returns.
"This would be another blow to individual investors, who are already suffering from the delay in the fiduciary-standard rules," said Joe Ziemer, a vice president of Betterment.
The current provision is only in the Senate bill, not in the bill passed by the House of Representatives. It requires investors who are selling part of a holding to assume that lots of securities bought at different prices are sold on a "first-in, first-out," or FIFO basis.
Although the change would no longer affect securities sold by managers of active or passive mutual funds and exchange-traded funds, it would affect individuals who sell part of their investment in such funds.
Here's how. Say an investor owns two lots of a sector fund bought at different prices, and they are in a taxable account rather than a tax-deferred retirement account. If the fund is trading at $90 per share now, each one acquired five years ago for $65 would have a $25 taxable gain.
But each share bought two years ago for $110 would have a $20 loss.
Under current law, investors can choose which fund shares to part with. So selling the ones that cost $110 would produce a loss to offset other gains, while selling the ones that cost $65 would produce a taxable gain.
If the provision is enacted, the first shares sold would be assumed to have a cost of $65 each, and the investor couldn't sell the $110 shares until the $65 shares were gone.
The provision would, however, allow investors in funds and dividend-reinvestment plans who can use the "average cost" method of computing taxable gain to continue to use it.
Other details of the provision are unclear. For example, it isn't known how the Internal Revenue Service could tell if an investor with many lots of one security moved one of them to a different brokerage firm and then sold it. Brokers only report to the IRS information about what's held at that firm.
The change would also affect taxpayers' ability to maximize the value of charitable donations of appreciated shares.
Under current law, investors often can skip paying capital-gains tax on donated shares, while getting deduction for their full market value. But the best shares to give may not be the first acquired.
Advisers urge investors who already intended to sell or donate specific lots that aren't the first acquired to do it before year-end.
"State taxes will also rise if that deduction is repealed, so parting with securities now may be a good option," says tax strategist Robert Gordon of Twenty-First Securities.
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