## Capital gains - tax treatment

### Capital gains - tax treatment

I'm uncertain how to handle investments that are subject to capital gains tax treatment.

As an example, consider an investment property which was originally purchased some years ago for $100,000. Its current value is $300,000. I'll assume it will appreciate at 4% per year going forward, so I'll enter a COLA of 4%. Let's say I sell it 5 years from now, when its value has appreciated to about $365,000. My understanding of US tax law is that I will pay tax on the capital gains of $265,000, and that this will be taxed at the long-term capital gains rate, which is now 15%.

How should this be modeled in FRP? I assume it should be coded as tax-deferred savings. (Not taxable, since the annual gains are not taxed each year.) But how do I model the taxes?

As an example, consider an investment property which was originally purchased some years ago for $100,000. Its current value is $300,000. I'll assume it will appreciate at 4% per year going forward, so I'll enter a COLA of 4%. Let's say I sell it 5 years from now, when its value has appreciated to about $365,000. My understanding of US tax law is that I will pay tax on the capital gains of $265,000, and that this will be taxed at the long-term capital gains rate, which is now 15%.

How should this be modeled in FRP? I assume it should be coded as tax-deferred savings. (Not taxable, since the annual gains are not taxed each year.) But how do I model the taxes?

### Re: Capital gains - tax treatment

My understanding is that FRP calculates taxes annually on the returns on your "tax deferred" savings using the ordinary tax rate (because it assumes that these are all distributions from IRAs and tax deferred retirement accounts that are taxed at ordinary income tax rates). FRP calculates taxes annually on the returns on your "taxable" savings using the investment tax rate (i.e., a blend of the capital gains and ordinary income tax rates that you expect to incur on interest, dividends and gains from the sale of investments in taxable accounts). So if you try to simulate deferral on growth assets by sticking them in your "tax deferred" savings in FRP, you will be computing taxes on all of your capital gains on your taxable investments at the higher ordinary income tax rate.

So the way that I have dealt with the unrealized gains on investment property that is added to my plan is to calculate the capital gains tax that would apply if I were to sell the property on the date that it is added to the plan, then subtract the amount of the tax from the value of the property. For example, in the case of the property that you described in your posting, I would compute the 15% tax on the $200,000 of unrealized gain on day one, subtract that $30,000 tax from the value of the asset, and enter the resulting after-tax value of $270,000 as the day one value of the property in FRP. From that point forward, FRP will compute (per your example) a 4% annual return on the asset and deduct tax on that 4% return at the 15% investment tax rate. So after one year, the asset would have an after-tax value of $279,180 ($270,000 * ( 1 + 4%*85% )). Assuming you use a 3% inflation rate for your plan, FRP would report this new value in present dollars as $271,049 ($279,180 / 1.03). This approach makes sure that you have accounted for taxes on all of the unrealized appreciation on your taxable assets. The downside is that when you update the values of the taxable assets contributed to your plan, you may need to recompute the after-tax value of these assets based on the updated amount of unrealized appreciation in these assets.

So the way that I have dealt with the unrealized gains on investment property that is added to my plan is to calculate the capital gains tax that would apply if I were to sell the property on the date that it is added to the plan, then subtract the amount of the tax from the value of the property. For example, in the case of the property that you described in your posting, I would compute the 15% tax on the $200,000 of unrealized gain on day one, subtract that $30,000 tax from the value of the asset, and enter the resulting after-tax value of $270,000 as the day one value of the property in FRP. From that point forward, FRP will compute (per your example) a 4% annual return on the asset and deduct tax on that 4% return at the 15% investment tax rate. So after one year, the asset would have an after-tax value of $279,180 ($270,000 * ( 1 + 4%*85% )). Assuming you use a 3% inflation rate for your plan, FRP would report this new value in present dollars as $271,049 ($279,180 / 1.03). This approach makes sure that you have accounted for taxes on all of the unrealized appreciation on your taxable assets. The downside is that when you update the values of the taxable assets contributed to your plan, you may need to recompute the after-tax value of these assets based on the updated amount of unrealized appreciation in these assets.

### Re: Capital gains - tax treatment

Eric,

Sorry I missed your post initially. If I read it correctly, trfrp's suggested approach seems like a good way to accomplish what you're trying to do. (thanks trfrp!).

To clarify how the taxes work, with tax deferred accounts, taxes are only deducted from withdrawals, not from year to year investment gains. That's the whole idea behind the tax deferral. The investment grows without any tax burden, then taxes are taken from withdrawals. So the tax basis of the tax deferred portfolio is always assumed to be 0% of the balance and all withdrawals are taxed in full at the ordinary income tax rate.

OTOH, the basis of the taxable portfolio is assumed to be 100% of the balance at all times. Any investment gains are taxed in full at the investment tax rate in the year they happen. This means that withdrawals from taxable accounts are not taxed at all. Usually, this simplification is workable, even though it doesn't represent the reality that we usually have at least some unrealized gains in our taxable portfolios.

Another way to handle a planned sale of a capital asset is to leave the asset out of the plan initially, then create a 'Taxable Savings' cash flow in additional inputs that adds the expected net proceeds from the sale into your taxable portfolio in the year you expect to sell the asset. This requires manually computing the future net gain, so it's a bit of a pain, but it gives you total control of how much cash gets injected into your taxable portfolio as a result of the sale.

This alternate approach isn't any better than what trfrp proposed, but some folks feel that doing it this way is clearer.

Jim

Sorry I missed your post initially. If I read it correctly, trfrp's suggested approach seems like a good way to accomplish what you're trying to do. (thanks trfrp!).

To clarify how the taxes work, with tax deferred accounts, taxes are only deducted from withdrawals, not from year to year investment gains. That's the whole idea behind the tax deferral. The investment grows without any tax burden, then taxes are taken from withdrawals. So the tax basis of the tax deferred portfolio is always assumed to be 0% of the balance and all withdrawals are taxed in full at the ordinary income tax rate.

OTOH, the basis of the taxable portfolio is assumed to be 100% of the balance at all times. Any investment gains are taxed in full at the investment tax rate in the year they happen. This means that withdrawals from taxable accounts are not taxed at all. Usually, this simplification is workable, even though it doesn't represent the reality that we usually have at least some unrealized gains in our taxable portfolios.

Another way to handle a planned sale of a capital asset is to leave the asset out of the plan initially, then create a 'Taxable Savings' cash flow in additional inputs that adds the expected net proceeds from the sale into your taxable portfolio in the year you expect to sell the asset. This requires manually computing the future net gain, so it's a bit of a pain, but it gives you total control of how much cash gets injected into your taxable portfolio as a result of the sale.

This alternate approach isn't any better than what trfrp proposed, but some folks feel that doing it this way is clearer.

Jim

### Re: Capital gains - tax treatment

trfrp: Thanks very much. Nicely explained. I'm a newcomer to FRP, and just trying to figure it all out.

jimr: What's the rationale for the 15% default value for investment tax rate? I understand that it's a variable, subject to adjustment based on individual circumstances. But the 15% looks suspiciously like the capital gains tax rate. Is that just coincidence? Alternatively, maybe it's based on a 30% default Income Tax Rate along with an assumed 50% annual turnover.

Thanks to you both for your explanations!

jimr: What's the rationale for the 15% default value for investment tax rate? I understand that it's a variable, subject to adjustment based on individual circumstances. But the 15% looks suspiciously like the capital gains tax rate. Is that just coincidence? Alternatively, maybe it's based on a 30% default Income Tax Rate along with an assumed 50% annual turnover.

Thanks to you both for your explanations!

### Re: Capital gains - tax treatment

I think it is a coincidence but I don't exactly remember. The idea was for this to be a relatively conservative default for the majority of people. The fact that there's no accounting for unrealized gains makes it a bit more conservative already, but then again, most folks also get hit with state capital gains taxes on top of federal taxes and I think the default tried to account for that at least somewhat.eric wrote:But the 15% looks suspiciously like the capital gains tax rate. Is that just coincidence?

If you're up for an exercise you might find this interesting:

1) Save any unsaved data then click on 'new' to get a new plan.

2) Enter $400,000 each for Taxable Portfolio Value and Tax Deferred Portfolio (leave everything else as default)

3) Click the 'Sensitivity Analysis' button

4) For parameter 1, Select income tax rate with min=5% and max=30%

5) For parameter 2, select investment tax rate with min=5% and max=30%

6) Click 'Run Sensitivity Analysis'

7) Notice that as the tax rates increase from 5% to 30%, the probability of success decreases from around 98% down to 92%.

8) Next, change parameter 2 to 'Portfolio Std Dev' (last pick in menu) with min=2% and max=25%

9) Click 'Run Sensitivity Analysis' again

10) Notice how much more sensitive this plan is to std dev changes compared to the investment tax rate.

The idea of this is to show a way to figure out which inputs are likely to have the biggest impact on your specific plan. Then you can focus your energy on specifying those inputs with as much precision as is practical.

Depending on the exact details of your plan, the investment tax rate might not matter very much, or maybe it matters a lot. This is a handy way to better understand the contours of your plan and which things it's most dependent on.

Jim

### Re: Capital gains - tax treatment

Jim: Thanks very much. I'll give it a try.

Regarding your earlier suggestion:

Capital asset purchased at $100,000, now valued at $300,000

Inflation = 3%

Annual growth rate for the asset = 4% for the asset

Sell asset in 10 years.

Assumed cash flow = $100,000 + ($200,000 minus 15% capital gains tax) = $270,000. Compute future net gain by appreciating asset at 1% per year. So enter Annual Amount = 270,000^(1.01^10). Start Year will be the same as End Year, to represent a one-time cash flow rather than a recurring annual cash flow.

Is that right?

Regarding your earlier suggestion:

Just to make sure I understand the idea... Assuming:Another way to handle a planned sale of a capital asset is to leave the asset out of the plan initially, then create a 'Taxable Savings' cash flow in additional inputs that adds the expected net proceeds from the sale into your taxable portfolio in the year you expect to sell the asset. This requires manually computing the future net gain, so it's a bit of a pain, but it gives you total control of how much cash gets injected into your taxable portfolio as a result of the sale.

Capital asset purchased at $100,000, now valued at $300,000

Inflation = 3%

Annual growth rate for the asset = 4% for the asset

Sell asset in 10 years.

Assumed cash flow = $100,000 + ($200,000 minus 15% capital gains tax) = $270,000. Compute future net gain by appreciating asset at 1% per year. So enter Annual Amount = 270,000^(1.01^10). Start Year will be the same as End Year, to represent a one-time cash flow rather than a recurring annual cash flow.

Is that right?

### Re: Capital gains - tax treatment

Yes on the start year=end year, but for this type of stuff I like to spend a bit of time playing around in excel to make sure I understand all the moving parts.

### Re: Capital gains - tax treatment

Actually, I don't think you clear 1% per year because part of the 4% growth gets eaten by taxes doesn't it?

### Re: Capital gains - tax treatment

I think you're right. Capital gains tax is assessed based on the nominal value of the asset, not the inflation-adjusted value. So in my example, the asset is now worth $300,000. It grows at a 4% rate over the next 10 years, to a value of 300,000*(1.04^10) = about 444,000. I pay tax on the gain, which is 444,000 - 100,000 = 344,000. For most people the long-term capital gains tax is 15%. So the tax will be 15% of 344,000, which is 51,000.jimr wrote:Actually, I don't think you clear 1% per year because part of the 4% growth gets eaten by taxes doesn't it?

I'm going to have to think this through more carefully.

That's the trouble with the capital gains tax: it's assessed on gains caused by inflation. So even if the value of an asset remains unchanged in real dollars, capital gains tax is due when it's sold.

I wish that FRP would do these calculations. Have you considered adding this functionality? Capital assets - such as investment property or appreciated stocks held for a long time - are a very common asset type.

### Re: Capital gains - tax treatment

Eric, you're almost there. Your after-tax proceeds in year 10 are $444k - $51k = $393k. Now compute the present value of those proceeds at your assumed 3% inflation rate: $393k / 1.03^10 = $292k. Now input an increase to your taxable savings in year 10 of $292k with a COLA that "Tracks Inflation". If you adopted my suggestion of inputting $270k in year 1 rather than $292k in year 10, then the $270k from year 1 would grow at an after-tax rate of 3.4% (4%*85%) for 10 years to a total of $377k. The present value of that figure, at a 3% inflation rate, would appear in FRP on the line for year 10 as $281k. So my approach is a bit more conservative, but the answers are pretty close. The only reason I would bother to model out a future sale of an appreciated capital asset is if I were assuming a significant change in my tax rates over time.

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