Can you step up your cost basis indefinitely via the 0% capital gains rate?

Question

I had asked a previous question about moving money between mutual funds without taxation due to the 0% capital gains rate for those in low tax brackets.

However, I realized that this 0% rate actually allows much more than that. It allows you to step up your cost basis for free every year. If I understand right, as long as you remain in the 15% tax bracket or lower (currently taxable income up to $36k for a single filer), capital gains are taxed at 0%. This would mean that, at the end of every tax year, if any of your investments had increased in value, you could sell as much as possible while remaining under this limit and then immediately buy it back, thereby stepping up your cost basis and reducing future tax liability. If these investments were mutual funds that could be traded for free, you would get this tax benefit with zero cost. It would be similar to loss harvesting, only it's gain harvesting, realizing a gain tax-free.

By searching, I was able to find a couple web pages mentioning this loophole (e.g., this one). But given how often you see "10 Tips to Reduce Your Tax Bill"-type articles in the newspaper, online, etc., I was surprised that I had never seen this one mentioned before. With deductions and exemptions, a married couple could have taxable income in the 0% range while earning well more than the median household income in the USA (roughly $50k according to Wikipedia). This would seem to mean that more than half the US population could potentially reduce their future capital gains taxes for free (if they had capital gains to realize).

So basically what I'm wondering is, is there a catch? Is this loophole for real? If so, why isn't it more widely known (compared to the various "tax tips" you see around about making IRA contributions and the like)? Why doesn't everyone do this? Is it just that most people earning below the 0% limit don't have much in the way of investments in taxable accounts, so they can't make use of the loophole?

Answer 1

Your real question, "why is this not discussed more?" is intriguing. I think the media are doing a better job bringing these things into the topics they like to ponder, just not enough, yet.

You actually produced the answer to How are long-term capital gains taxed if the gain pushes income into a new tax bracket? so you understand how it works.

I am a fan of bracket topping. e.g. A young couple should try to top off their 12% bracket by staying with Roth but then using pretax IRA/401(k) to not creep into 22% bracket.

For this discussion, 2018 numbers, a blank return (i.e. no schedule A, no other income) shows a couple with a gross $101,400 being at the 12%/22% line. It assumes the $24K standard deduction is used, actual return may have higher numbers.

The last clean Distribution of Income Data is from 2006, but since wages haven't exploded and inflation has been low, it's fair to say that from the $101,400 representing fewer than the top 20% of earners, it won't have many more than top 25% today. So, yes, this is a great opportunity for most people.

Any married couple with under that $101,400 figure can use this strategy to exploit your observation, and step up their basis each year. To littleadv objection - I imagine an older couple grossing $75K, by selling stock with $10K in LT gains just getting rid of the potential 12% bill at retirement. No trading cost if a mutual fund, just $20 or so if stocks.

The more important point, not yet mentioned - even in a low cost 401(k), a lifetime of savings results in all gains being turned in ordinary income. And the case is strong for 'deposit to the match but no no more' as this strategy would let more than 2/3 of us pay zero on those gains.

(To try to address the rest of your questions a bit - the strategy applies to a small sliver of people. 25% have income too high, the bottom 50% or so, have virtually no savings. Much of the 25% that remain have savings in tax sheltered accounts. With the 2018 401(k) limit of $18,500, a 40 year old couple can save $37,000. This easily sucks in most of one's long term retirement savings. We can discuss demographics all day, but I think this addresses your question.)

If you add any comments, I'll probably address them via edits, avoiding a long dialog below.

Answer 2

As JoeTaxpayer illustrated, yes you can. However, one thing to remember is that unless you live in a state with no state income tax, there may be state tax to pay on those gains. Even so, it's likely a good idea if you expect either your income (or the federal capital gains tax rate) to rise in the future.

Answer 3

More generally, a progressive tax favors as even a distribution of income as possible. Someone making $200,000 one years and $0 the next will pay more tax than someone making $100,000 each year. The optimal strategy is to claim gains in such a way that your income is the same each year. The "capital gains" classification complicates the issue a bit in that with two different "types" of income, with different tax treatment, evening out your year-to-year capital gains income may mean increasing your total income variation.

You probably don't know exactly how much you will be making, so the exact optimal amount can't be calculated, but it will definitely be at least how much you can claim without increasing your tax liability any particular year. Given the sharp discontinuities in capital gains rate, you likely won't benefit from claiming more.