Friday, March 13, 2009

A Strategy For Capital Gains: Treat All Taxpayers like the Secretary of the Treasury

Section 1043 of the Internal Revenue Code permits those appointed to high-level positions in the executive branch (not Congress or the Judiciary) a one-time tax-free capital gains rollover.

Individuals who must sell assets to comply with federal ethics laws are allowed to convert them into Treasury securities or shares in broad-based mutual funds. No tax applies to the transaction until the Treasury securities or mutual funds are sold. The underlying basis carries forward so that all accumulated gains are taxed unless they are held to death, at which point basis would be stepped up to market value.

This provision was extraordinarily valuable to Robert Rubin and Henry Paulson, both of whom had hundreds of millions of dollars in unrealized capital gains in Goldman Sachs stock. When they were appointed secretary of the Treasury, they were able to realize all the gains on their stock shares, saving them tens of millions of dollars in taxes, and diversify their portfolios at the same time.

What I have always found interesting about this obscure provision of the tax law is that it recognizes a principle that ought to apply to all taxpayers. That principle is that reinvested capital gains ought not to be taxed; they should be taxed only when consumed. The way we tax capital gains now, it is more of a transactions tax than a tax on income, preventing people from being able to diversify their portfolios and leaving them locked into assets on which they have large gains.

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