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This article analyzes the optimal dynamic consumption portfolio problem in the presence of capital gains taxes. It explicitly takes into account limited capital loss deduction and the 3,000 dollar amount that can be offset against other income. Constantinides (1983) shows that in tax-systems where capital gains and losses are subject to the same taxable treatment, it is is optimal to realize capital losses immediately. We generalize this finding to tax-systems where limited amounts of losses can be used against other income. In such tax-systems, the investment decision becomes substantially more difficult for two reasons. First, the investor has the opportunity of offsetting limited amounts of losses against other income. Hence, she has to make a decision on how to use a loss,i.e. whether to offset it against realized capital gains or to potentially postpone the realization of capital gains and offset it against other income. Second, because the tax rate on other income usually exceeds that on capital gains, in our setting it can be optimal to realize capital gains immediately, which prevents investors from getting locked in and helps to keep portfolios diversified.
Abstract
Optimal Tax-Timing and Asset Allocation when Tax Rebates on Capital Losses are Limited
Marekwica, MarcelThis article analyzes the optimal dynamic consumption portfolio problem in the presence of capital gains taxes. It explicitly takes into account limited capital loss deduction and the 3,000 dollar amount that can be offset against other income. Constantinides (1983) shows that in tax-systems where capital gains and losses are subject to the same taxable treatment, it is is optimal to realize capital losses immediately. We generalize this finding to tax-systems where limited amounts of losses can be used against other income. In such tax-systems, the investment decision becomes substantially more difficult for two reasons. First, the investor has the opportunity of offsetting limited amounts of losses against other income. Hence, she has to make a decision on how to use a loss,i.e. whether to offset it against realized capital gains or to potentially postpone the realization of capital gains and offset it against other income. Second, because the tax rate on other income usually exceeds that on capital gains, in our setting it can be optimal to realize capital gains immediately, which prevents investors from getting locked in and helps to keep portfolios diversified.