Dealing with Unrealized Capital Gains

Readers often email me to ask what to do when you have asset that you’d like to sell, but which has a large unrealized capital gain. The two most common examples being:

1. Shares of a given stock which now make up far too high a percentage of their overall net worth, or
2. An actively managed mutual fund with unreasonably high costs.

Generally, my suggestion is as follows:

First, calculate precisely how much you would owe if you were to sell the asset. If we assume you’ve held the asset for greater than one year, the Long-Term Capital Gain would be taxed at a rate of 15% (unless you’re in a tax bracket of 15% or lower, in which case LTCGs are taxed at a rate of 5%).

Next, weigh the cost of that taxation against the benefits of having an appropriately-balanced portfolio.

Holding Too Much of One Stock

For example, let’s say you own shares of a stock and (in total) they’re currently valued at $100,000. You purchased them (all at the same time, at the same price) for $30,000.

If you were to sell all of your shares, you’d be realizing a LTCG of $70,000. Assuming you’re in the 25% (or greater) tax bracket, the gain will be taxed at a rate of 15%, meaning you’d be paying $10,500 in tax.

Is that too high a price to pay for diversification? If this $100,000 makes up a significant portion of your net worth, it may be wise to accept that 10.5% decline in value now rather than expose yourself to the much larger potential losses that can come from having so much money invested in one company.

It’s also important to note that, assuming you plan on selling the shares at some point in the future (and assuming they don’t decrease in price), you’re going to be paying this tax eventually.

Selling Actively Managed Funds

Alternatively, let’s imagine that you own an actively managed fund and would like to sell it (having been convinced of the benefits of index funds), but your cost basis is significantly below the current value. (Again, let’s use $30,000 and $100,000.)

Again, if you sell, you incur a cost of 10.5%. Essentially the question comes down to how long it will take for the reduced expenses to recoup the tax paid. Often, it’s a much shorter time than you’d think.

For example, it wouldn’t be unheard of for your total costs to decrease by 2% per year or more:

• 0.75% via a lower published expense ratio
• 0.50% via lower turnover
• 0.75% via increased tax efficiency (which is relevant given that we’re obviously dealing with a taxable account here).

At that rate, it would take barely 5 years before your savings more than outweighed the cost of paying the tax. (And you’d now have a higher cost basis in your holding as well, meaning that when you sell the index fund at a later date, you won’t be paying as much tax as you would had you held the original fund.)

In Summary…

Obviously, this sort of situation is something that must be considered on a case-by-case basis. That said, in my own experience, I find that investors tend to overestimate the cost of selling and underestimate the benefits of having an appropriately constructed portfolio.

One final note: In the above analysis, I assume that you don’t have any investments which a) you’d like to sell, and which b) have unrealized capital losses. If you do have such investments, the solution sometimes becomes a no-brainer: Sell both, use the capital losses to offset the capital gains, and invest the cash as you choose.

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