What is Effective Capital Gains Tax Rate?

CFA Level III
#1

Stupid question but I’m having trouble wrapping my brain around what this tax rate represents? In the Schweser text, I know why they build up to this point… they show you how to calculate the weighted average tax rate on a portfolio after you incorporate income, dividends and realized cap gains. However this effective tax rate you calculated ignores the deferred cap gains… and then it leads into this next concept, the effective capital gains tax rate.

So does this tax rate merely represent, had those deferred gains been realized, this is the tax rate you pay on those deferred gains?

#2

Since the unrealized capital gains are deferred they are allowed to compund which effectively reduces the actual tax. The formula is broken down like this:

Effective Capital Gains Tax Rate =

Stated Capital Gains Tax Rate * (Proportion of portfolio gains deferred/ Annual Return after Realized Taxes)

Tcg * (1 - Pi - Pd - Pcg] / 1 - PiTi - PdTd - PcgTgc)

-So the higher the annual return after realized taxes the lower the effective CG tax rate

-Greater proportion of gains deferred will result in higher effective CG tax rate

#3

The way I think about it is it’s = deferred capital gains tax * % weight / income before deferred capital gains

I figure the denominator because if you apply that percentage to pretax income, the only thing left to tax would be deferred capital gains tax.

#4

its the one with the really messed up long formula.

just remember that for now.

and that it factors in the accrued p&l

#5

I realize that this is the year after, but I’m reading through the exact same Shweser page and had exactly the same question (and someone else probably will too). I think your denominator might be misrepresented as it isn’t an annual return.

I read the formula as:

Effective Capital Gains Tax Rate =

Stated Capital Gains Tax Rate * (Proportion of portfolio gains deferred/ Proportion of realized gains you kept)

OR

Stated Capital Gains Tax Rate * (unrealized gains as a % of after tax realized gains).