Indexing Capital Gains to Inflation: Potential Relief Complicated by Execution Challenges

As midterm elections approach, a proposed tax break has resurfaced: indexing capital gains to inflation. While the concept sounds appealing to individual investors seeking to reduce tax burdens, experts warn that the implementation could introduce significant complexities.

Indexing capital gains to inflation involves adjusting an asset’s cost basis so that capital gains taxes are levied on real economic appreciation rather than nominal increases driven solely by inflation. The idea recently gained attention following an August opinion piece in the Wall Street Journal, which described the proposal as “big relief to middle-class taxpayers.”

“Indexing capital gains would adjust your basis for inflation so that the tax is more closely imposed on real economic gain,” explained Cary Sinnett, a certified financial planner and director of personal financial planning at the American Institute of Certified Public Accountants.

Under current tax laws, if an investor purchased a stock for $100 a year ago and sold it today at $102—amidst a 2% annual inflation rate—they would pay taxes on the full $2 nominal gain, even if inflation accounted for most of the increase. Currently, the top long-term capital gains rate stands at 20%, plus a 3.8% net investment income tax for households with modified adjusted gross income exceeding $200,000 for single filers and $250,000 for joint filers. Short-term capital gains are taxed at ordinary income rates, which can reach up to 37%.

“The idea behind this potential legislation is to adjust for that inflation rate,” Sinnett noted. “It seems simple on the surface, but there are some substantial complexities.”

Incentivizing Long-Term Investing

Long-term investors could stand to benefit the most from indexing capital gains to inflation. For instance, if an investor holds a high-growth stock for just over a year, the inflation adjustment would likely be minimal due to the short holding period. However, for assets held over a decade, compounding inflation could lead to a substantial reduction in taxable gains.

“It’s great for the long-term investor,” Sinnett said. “You’re more likely going to see a cultural push to hold, and get that step-up for inflation.” Additionally, indexing could encourage investors to rebalance portfolios or redeploy capital rather than holding onto highly appreciated assets solely to avoid tax liabilities.

According to an analysis by the Tax Foundation, households with the highest incomes would see the greatest benefit. Projected for 2036, taxpayers would see an average after-tax income boost of 0.4%, with the top quintile experiencing a 0.6% increase, while the bottom quintile would see a rise of less than 0.05%.

Execution Challenges and Complexities

Applying an inflation adjustment across a diverse investment portfolio, however, is far from straightforward. While brokerage houses might handle the calculations for standard securities, taxpayers would likely be responsible for tracking inflation adjustments for assets like collectibles, real estate, and privately held companies, according to Tim Steffen, a CPA and director of advanced planning at Baird.

The complexity increases further with dollar-cost averaging, where investors buy shares at regular intervals. “The complexity of dollar-cost averaging makes it difficult to track what your cost basis is,” Sinnett warned. “It is up to you to maintain the cost basis.” Similarly, tracking cost bases for dividend reinvestments would become more complicated.

Another challenge lies in handling depreciating assets. “Now I’m selling with a larger realized loss than I would’ve had previously because of inflation,” Sinnett explained. “If the investor invests $100,000, and the inflation-adjusted basis becomes $130,000, but the asset sells for $115,000, that’s a gain of $15,000 in the current system, but it could be a loss of $15,000 in the new system.”

Political and Practical Hurdles

Despite the potential benefits, the prospect of indexing capital gains to inflation faces an uphill battle. Garrett Watson, vice president of federal tax policy at the Tax Foundation, suggests that a more comprehensive legislative effort would be required to implement it correctly. Politically, the proposal’s best chance may have passed during the previous administration’s tax reform discussions.

Democrats remain skeptical due to the significant revenue costs associated with the adjustment. Furthermore, with midterm elections on the horizon, any major tax legislation faces uncertain prospects in a potentially divided Congress. For policymakers, the Treasury, and the IRS, failing to tax inflation-driven “fictitious” income continues to represent a substantial revenue challenge.

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