Adjusting capital gains for inflation could prove a mess for individual investors
Midterm elections are looming, and a proposed tax break has resurfaced: a call to index capital gains to inflation. While the idea sounds tempting for individual investors, the execution could come with plenty of headaches. Indexing capital gains to inflation involves adjusting the basis of an asset so that capital gains taxes are applied to its actual appreciation – and not just the increase in value tied to rising inflation. The notion reemerged in an August opinion piece in the Wall Street Journal , calling it a “big relief to middle-class taxpayers.” “Indexing capital gains would adjust your basis for inflation so that the tax is more closely imposed on real economic gain,” saidCary Sinnett, certified financial planner and director of personal financial planning at theAmerican Institute of Certified Public Accountants. For example, if you bought a stock a year ago for $100, and it’s trading today at $102 with an annual inflation rate of 2%. Under today’s capital gains treatment, if you were to sell that stock, you’d be subject to taxes on that $2 increase in the price, even if much of it came from inflation, according to Sinnett. Currently, the top long-term capital gains rate is 20%, plus a 3.8% net investment income tax that applies to households with modified adjusted gross income over $200,000 for single filers, and $250,000 for those married filing jointly. Short-term capital gains are taxed at the same rate as ordinary income, which can be as high as 37%. “The idea behind this potential legislation is to adjust for that inflation rate,” Sinnett said. “It seems simple on the surface, but there are some substantial complexities.” Incentivizing long-term investing Long-term investors could see the greatest impact from a change to capital gains tax treatment, according to Sinnett. Assume that an investor buys a high-growth stock and it surges 20% over the course of one year and one day – meaning these are long-term capital gains. If that investor sells it, the appreciation is subject to tax, but the inflation adjustment may not be large because of the short time period, he said. Meanwhile, if the investor bought a stock and held it for 10 years, then that could be enough time for inflation to compound and for that shareholder to see a meaningful adjustment to capital gains. “It’s great for the long-term investor,” said Sinnett. “You’re more likely going to see a cultural push to hold, and get that step-up for inflation.” Similarly, indexing gains to inflation could also encourage investors to consider redeploying capital and rebalancing if they’re sitting on significant appreciation. “Right now, there is a tendency to hold onto investments with a large embedded capital gain,” Sinnett added. “Sometimes investors avoid selling highly appreciated assets because of tax consequences.” Households with the highest incomes would see the greatest benefit from indexing capital gains to inflation. On average in 2036, taxpayers would see an after-tax income boost of 0.4%, with those in the top quintile seeing a lift of 0.6%, while those in the bottom quintile get an increase of less than 0.05%, according to an analysis from the Tax Foundation . A trade off Applying an inflation adjustment to one asset may sound simple, but using this treatment on an array of investments could be complex. For starters, even as brokerage houses would likely take on the duty of calculating the inflation adjustment for most assets, other investments – such as collectibles, real estate or privately held companies – would likely be the taxpayer’s responsibility, said Tim Steffen, CPA and director of advanced planning at Baird. Another consideration is what happens when investors dollar-cost average into a certain asset over time, meaning you’re buying shares at regular intervals regardless of the price. “The complexity of dollar-cost averaging makes it difficult to track what your cost basis is,” said Sinnett. “It is up to you to maintain the cost basis.” Similarly, basis tracking for dividend reinvestments could also become more complicated with this additional adjustment, Steffen said. Finally, there’s the question of what happens when an investor considers selling a stock that’s been falling. “Now I’m selling with a larger realized loss than I would’ve had previously because of inflation,” Sinnett said. “If the investor invests $100,000, and the inflation-adjusted basis becomes $130,000, but the asset sells for $115,000, that’s a gain of $15,000 in the current system, but it could be a loss of $15,000 in the new system,” he added. Don’t hold your breath The idea behind inflation-adjusted gains has resurfaced, but it’s not likely to find traction, according to Garrett Watson, vice president of federal tax policy at the Tax Foundation. “To do it right, a more comprehensive effort is needed,” he said. “Politically, the best shot was probably last year.” President Donald Trump’s package of tax changes in the ” One Big Beautiful Bill Act ” last year lifted the cap on state and local tax deductions and added new breaks for taxes on tips and overtime pay. Democrats in Washington are skeptical of adjusting capital gains for inflation because of the revenue cost, and any proposal would face a challenge after the midterms elections if there is shared control of Congress, Watson added. For Congress, the Treasury and the Internal Revenue Service, “you lose more and more revenue from not taxing that growing fictitious income,” the tax analyst said.
