Portfolio Choice with Capital Gain Taxation and the Limited Use of Losses

We study the consumption-portfolio problem with realized capital gain taxation. The distinguishing feature of our analysis is that we impose on the model an important element of the tax code that has received little attention in the academic literature: the limited use of capital losses. Existing capital gain tax portfolio choice work assumes the full use of capital losses (FUL). We show that this common assumption leads to counterfactual welfare results. Due to the tax rebates generated from tax loss selling, an untaxed investor would actually prefer to pay a capital gain tax. Instead, when only the limited use of capital losses (LUL) is allowed for, which is consistent with the U.S. tax code, an investor's optimal equity-to-wealth ratio is shown to be strongly non-monotonic in the portfolio's tax basis. For a tax basis significantly below the current stock price, LUL investors with no unrealized capital losses trade equity similar to FUL investors as the probability of tax loss selling in the future is small. For a tax basis close to the current stock price, LUL investors hold significantly less equity relative to FUL investors and untaxed investors. When LUL investors have large unused capital losses or a tax basis significantly above the current stock price, they trade as if they are not taxed on capital gains because they can use accumulated capital losses to offset any future taxes. This difference in trading strategies and the usage of capital losses leads to lower lifetime wealth and equity holdings for LUL investors relative to FUL investors and untaxed investors. These wealth and equity holding reductions are small under parameters from the current U.S. tax code, but are larger for capital gain tax rates consistent with past U.S. tax codes as well as tax codes in several foreign countries.