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Factoring inflation into the capital loss deduction: is it time for reform?

The federal tax code reflects the concept of equity, rooted in fairness for individuals. Equity considerations appear in certain tax provisions aimed at mitigating the eroding impact of inflation; these provisions help provide relief to taxpayers coping with certain negative effects of inflation, such as decreased purchasing power. Congress recognized this issue and addressed it by indexing selected tax components, such as the annual gift tax exclusion, for inflation. The annual change in the consumer price index (CPI) drives this procedure.

Since 1997, the Internal Revenue Code (IRC) has provided for the annual gift exclusion to be indexed for inflation in $1,000 increments (IRC section 2503[b]). In 2002, for the first time, the annual exclusion was adjusted upward for cost-of-living increases, from $10,000 in 2001 to $11,000 in 2002, reflecting the level of inflation. From 2001 to 2011, the annual gift tax exclusion increased 30%, from $10,000 to $13,000. Moreover, the annual average CPI escalated from 177.1 to 224.94, a 27% increase, during the same time period ( Thus, the annual exclusion has grown to keep pace with inflation since 2001.

Some provisions of the tax code, however--such as the capital loss deduction--have not received similar treatment. The ensuing discussion explores its history and focuses on Congress's response or lack thereof--to inflationary trends when it comes to the capital loss deduction.

Capital Loss Deductibility

Due to tax relief provided by Congress that contained shades of the wherewithal-to-pay concept, IRC section 1211(b) enables an individual taxpayer to deduct for adjusted gross income (AGI) up to $3,000 of net capital losses per tax year. In addition, the net capital losses for the year that exceed the $3,000 maximum limit can be carried forward to future tax years indefinitely. Under IRC section 1211(b)(1), married taxpayers filing separately have their deduction capped at $1,500 per tax year. Whereas the deduction of net capital losses is set at a low level, realized capital losses are fully deductible, provided that they are offset by realized capital gains each year.

Numerous tax policy reasons can explain the limitation on the deductibility of capital losses. One rationale is that it mitigates or prevents taxpayers from manipulating the recognition of capital gains and losses by "cherry picking" certain activities. Thus, without a limitation, taxpayers could sell the loss assets and deduct them as such, while retaining the gain assets and deferring taxation by selling them later. Unlimited capital loss deductibility could lead to a significant decrease in federal tax revenues.

Increasing the deduction could also encourage similar incentive-driven behavior by taxpayers. The current federal budget climate, characterized by huge deficits, might be another reason to preclude raising the amount above $3,000. It is possible that the country is just not in a good enough fiscal position to afford such a proposal.

Factoring in Inflation

Established in 1976, the $3,000 maximum capital loss deduction remains the same today The level of the deduction has never been indexed to inflation. If inflation were factored in, the maximum deduction would be about $11,360 in 2010 (a 279% increase since 1976), according to a typical inflation calculator ( From 1976 to 2010, the annual average CPI increased from 56.9 to 218.056, an increase of 283%, producing an inflation-adjusted net capital loss deduction of $11,490 for 2010. An average annual CPI of 224.939 for 2011 resulted in a 295% increase since 1976 and yielded $11,850 of net capital loss deduction. In inflation-adjusted terms, the capital loss limitation has been reduced by approximately 75% (1 - [$3,000 $10,8501) since 1976.

Some measure of change in stock-market value might be an even more appropriate basis for adjustment than the change in the CPI. The CPI measures changes in the price-level of a market basket reflecting a sample of representative goods and services purchased by urban consumers; thus, it is a general measure of inflation. But capital losses are frequently linked specifically to stock values.

A metric related to equity investments--the Dow Jones Industrial Average (DJIA)--would generate much higher capital loss deductions. Founded in 1896, the DJIA is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and Nasdaq. From December 31, 1976, to December 31, 2010, the DJIA increased from 1,004.65 to 11,577.51 (, which reflects an increase of 1,052%. Applying this to maximum capital loss deduction would yield a value of $34,560 for 2010. Given a DJIA of 12,217.56 at the end of 2011 and a 1,116% increase from the end of 1976, the capital loss deduction would have been $36,480 for 2011 under this methodology.

In 2002, economist Larry Kudlow proposed doubling the amount that an investor could write off on an income tax return; however, this idea did not catch on with Congress. Using the aforementioned inflation calculator would yield a maximum deduction amount of $9,430 for 2002 (a 214% increase since 1976). With an annual average CPI of 179.9 for 2002 and an increase of 216% since 1976, the capital loss deduction would have been $9,480. Using the DJIA of 8,341.63 at the close of 2002, coupled with a 730% increase since 1976, the calculator would yield a $24,900 deduction.

In 2004, then--U.S. Congressman Nick Smith (R-Mich.) floated the idea of raising the net capital loss deduction to $9,000 and indexing it to inflation; however, the measure did not become part of the IRC. The inflation calculator used above would have produced an amount of $9,926 for 2004 (a 231% increase since 1976). With an annual average CPI of 188.9 for 2004 and an increase of 232% since 1976, the capital loss deduction would have been $9,960. The DJIA of 10,783.01 at the close of 2004, coupled with a 973% increase since 1976, would yield a $32,190 deduction.

The inflation calculator and annual average CPI methodologies produce similar results when used to adjust the capital loss deduction for inflation. They indicate that the capital loss deduction should have been adjusted to $11,000 and $12,000 for 2010 and 2011, respectively. The DJIA methodology, however, would generate amounts that the authors consider excessive.

Measuring Risk

Investing in stock means an investor should anticipate volatility, profit, and loss. Volatility is merely the relative rate at which the price of a security (e.g., equity) moves up and down over a period of time. Thus, volatility may be high or low depending upon the magnitude of swings in value, which reflects risk.

Beta is one measure of a stock's volatility. Stocks with a high beta (e.g., technology equities) tend to be more volatile and risky, but have the potential for greater returns. Stocks with a low beta (e.g., staple and utility equities) pose less risk and volatility, while offering lower returns most of the time. Thus, beta can be used as one measure of the relative risk presented by stocks.

Looking to the Future

Equity considerations in laws and provisions of the tax code can help mitigate the negative effects of inflation. The maximum annual capital loss deduction has not been adjusted for inflation, however. The examples above illustrate different methods by which the deduction could be adjusted for inflation and demonstrate how a lack of adjustment has eroded its value in real terms. The authors' intention is to attract attention to this issue and generate more discussion, and perhaps even reform, of the capital loss deduction.

Andrew D. Sharp, PhD, CPA, is a professor of accounting in the business division of Spring Hill College, Mobile, Ala.

Jessica M. Stieven, RAMS, is an operations and investment assistant for Archer Wealth Management, St. Louis, Mo.
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Title Annotation:tax policy
Author:Sharp, Andrew D.; Stieven, Jessica M.
Publication:The CPA Journal
Date:Feb 1, 2013
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