Factoring Inflation into the Capital Loss Deduction

By Sharp, Andrew D.; Stieven, Jessica M. | The CPA Journal, February 2013 | Go to article overview

Factoring Inflation into the Capital Loss Deduction


Sharp, Andrew D., Stieven, Jessica M., The CPA Journal


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 (TRC 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 (http://bls.gov/cpi/). 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-topay 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 $1 1,360 in 2010 (a 279% increase since 1976), according to a typical inflation calculator (http://www. westegg.com/inflation/). 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 $1 1,850 of net capital loss deduction. In inflation-adjusted terms, the capital loss limitation has been reduced by approximately 75% (1 - [$3,000 * $10,850]) 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. …

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