Optimizing Capital Gains and Losses

Wish #1: End the Long/Short-Term Gain Distinction

Ideally there would be no differentiation between short-term and long-term gains. Whether an asset is held for a microsecond or decade, the gain or loss should receive the same tax treatment.   A gain is a gain, a loss is a loss.  But as long as the tax code retains the current short-term/long-term bifurcation, it is important to account for the impact of short and long term gains.

Wish #2: Account for Inflation on Capital Gains

If you realize a capital gain of 10%, but inflation during that time is also 10% have you really earned anything?  According the the current tax code: Yes.  In real terms: No.  In fact, after taxes, you have lost real purchasing power.

I propose that the tax code be changed such that investors can optionally use the GDP deflator to adjust their cost basis when investments are sold.   The IRS could publish official monthly GDP deflator (inflation) data going back 1914.   Investors would have the option (on a sale-by-sale basis) of adjusting their cost basis upward by the ratio of the sale-month deflator to the purchase-month deflator.

In the 10% example, if you bought 100 shares of XYZ corp 4 years ago at $80 and sold those shares at $88 your traditional cost basis would be $8000 and your sales process would be $8800, resulting in a taxable $800 gain.  In my system your basis would be adjusted for inflation, making it $8800 — resulting in $0 of gain, and $0 of tax.   You wouldn’t pay for simply keeping up with inflation.

If, during the same time period you bought 100 shares of ACME corp at $100 each and sold them for $100 you would experience a long-term capital loss, because you lost real purchasing power.  Your revised basis would be $11,000 and proceeds $10,000 — resulting in a $1000 capital loss.

A Role for Optimization — Economic Reasoning and Tax Policy Seldom Coincide

The above wishes are likely to remain unrealized for years or decades to come.  Until then, it is important to factor in the implications of short-term, long-term, and unrealized gains and losses. This complexity can be more easily handled with a multi-objective optimization algorithm.

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