The proposal to adjust capital gains taxes for inflation aims to tax only ‘real’ economic gains, not those driven by rising prices. While beneficial for long-term investors and potentially encouraging portfolio rebalancing, the practical implementation presents significant complexities, especially for assets like real estate and strategies like dollar-cost averaging.
Experts caution that despite the appeal of taxing only true appreciation, political hurdles and potential government revenue losses make widespread adoption of inflation-adjusted capital gains unlikely in the near term.
The idea of adjusting capital gains for inflation, a proposal that surfaces periodically in discussions about tax policy, is once again gaining attention. While seemingly a straightforward way to ensure investors are taxed only on real profits, its implementation could introduce significant complexities for individual investors.
The core concept of indexing capital gains to inflation is to adjust the asset's cost basis by the rate of inflation. This means that any increase in the asset's value attributable solely to inflation would not be subject to capital gains tax. For instance, if an investor bought a stock for $100 and it appreciated to $102 in a year with 2% inflation, they would currently be taxed on the full $2 gain. With inflation indexing, the tax would only apply to the 'real' appreciation beyond inflation.
"Indexing capital gains would adjust your basis for inflation so that the tax is more closely imposed on real economic gain," explains Cary Sinnett, a certified financial planner and director of personal financial planning at the American Institute of Certified Public Accountants. The current capital gains tax rates include a top long-term rate of 20% (plus a 3.8% net investment income tax for higher earners) and short-term gains taxed at ordinary income rates, which can reach 37%.
Proponents argue that such a change would particularly benefit long-term investors. Over extended holding periods, inflation can significantly erode the real value of gains. For example, a stock held for a decade could see substantial nominal growth that is largely offset by cumulative inflation, meaning a much smaller portion of the gain would represent true economic profit.
"It's great for the long-term investor," Sinnett notes. "You're more likely going to see a cultural push to hold, and get that step-up for inflation." This could also encourage investors to rebalance their portfolios more readily, as the tax disincentive for selling highly appreciated assets would be reduced.
However, the practical application of inflation indexing is fraught with challenges. Tim Steffen, CPA and director of advanced planning at Baird, points out that while brokerage firms might handle calculations for many standard assets, taxpayers would likely be responsible for complex assets like collectibles, real estate, or privately held companies.
Further complications arise with strategies like dollar-cost averaging, where investors buy assets at regular intervals. "The complexity of dollar-cost averaging makes it difficult to track what your cost basis is," Sinnett states. Dividend reinvestments could also add to the tracking burden.
Perhaps more counterintuitively, indexing could also affect losses. If an asset's inflation-adjusted basis is higher than its selling price, a nominal loss could theoretically become a taxable gain if the adjustment outpaces the price decline. Sinnett provides an example: an investor buys an asset for $100,000. Inflation increases the adjusted basis to $130,000. If the asset is then sold for $115,000, under the current system, this would be a $15,000 gain. With inflation indexing, it could potentially be viewed as a $15,000 loss.
Despite the potential benefits, the path to implementing inflation-adjusted capital gains appears steep. Garrett Watson, vice president of federal tax policy at the Tax Foundation, suggests that significant political will and a comprehensive approach are needed. "To do it right, a more comprehensive effort is needed. Politically, the best shot was probably last year," he commented, referencing past tax reform efforts.
Democrats have expressed skepticism due to the potential revenue loss for the government. "For Congress, the Treasury and the Internal Revenue Service, you lose more and more revenue from not taxing that growing fictitious income," Watson added. Given these hurdles, significant changes to capital gains taxation related to inflation seem unlikely in the immediate future.
