Tax-Motivated Trading by Individual Investors

Abstract

We study the stock trades of a large number of individual investors to investigate how tax incentives affect the realization of capital gains and losses. We compare investors' realization behavior in their taxable and tax-deferred accounts, and thereby identify the effect of taxes on trading decisions. We reach four conclusions. First, we find clear evidence of a lock-in effect for capital gains in taxable accounts relative to tax-deferred accounts. We find evidence of the "disposition effect," the tendency for investors to hold losses and sell gains, in both types of accounts and especially at short holding periods. The lock-in effect is stronger for large stock transactions than for small ones. Second, we find tax-loss selling throughout the calendar year, though it is most pronounced in December. Tax loss trading is more pronounced among investors who have realized capital gains elsewhere in the portfolio during the year. Third, we observe substantial heterogeneity in individual investors' propensity to trade. Controlling for this heterogeneity, however, does not alter the relation between a stock's past performance and the realization decision. Finally, we find that relatively few investors repurchase stocks that they have sold at a loss, even after the 30-day "wash sale" holding period has expired. † We thank an anonymous discount broker for providing data on individual investors' trades and Terry Odean for his help in obtaining and understanding the data set. We are grateful to Doug Bernheim, three anonymous referees, and seminar participants at the 2004 AEA meetings, the Chicago Graduate School of Business, the Universities of Connecticut, Illinois, Michigan, and Minnesota, and the NBER Public Economics Meetings for very helpful suggestions. Ivković and Weisbenner acknowledge the financial support from the College Research Board at the University of Illinois at Urbana-Champaign; Poterba thanks the National Science Foundation. 1The realization-based capital gains tax in the United States presents investors with important opportunities for tax management. Constantinides (1984) demonstrates that the optimal strategy for taxable investors is to realize losses while deferring the realization of capital gains. Many other studies, such as Ritter (1988), Poterba and Weisbenner (2001), and Grinblatt and Moskowitz (2004), note that taxpayers with accrued capital losses have an incentive to realize these losses before the end of the tax year and thereby to reduce their income tax liability. Such year-end tax-loss selling is often cited as a contributory factor in the unusual behavior of stock returns in late December and early January.While there is no general theory of why investors trade assets, a number of recent empirical studies, notably Odean (1998), Barber and Odean (2000 and Grinblatt and Keloharju (2001), have shown that asset and household characteristics are related to trading probabilities.These studies raise questions about whether investor behavior accords with the predictions of simple models ...

Individual investors and financial disclosure

“…A possible concern with using portfolio records from one discount broker is whether these records are representative of the portfolios of the whole individual investor population. Previous studies provide some support for the validity of these brokerage data as they find that trades in the dataset are correlated with information reported on individuals' tax returns and with trades of other brokerage firms (e.g., Ivković, Poterba, and Weisbenner 2005;Barber and Odean 2008).…”

Hold or sell? How capital gains taxation affects holding decisions

“…Because capital gains crucially depend on the duration of an investment, we investigate investment decisions with exit flexibility. Despite the body of empirical literature on capital gains taxes and trading behavior (Bogart and Gentry 1995;Ivković et al 2005;Ayers et al 2008;Haesner and Schanz 2013) and the body of theoretical studies accounting for loss-offset opportunities in this context (Constantinides 1983;Stiglitz 1983;Nippel and Podlech 2011;Ehling et al 2013), all of these studies focused on listed corporations. However, little attention has been paid to the impact of capital gains taxation on both investment in corporate shares in general and the holding period under different tax systems.…”

Is There a Disposition Effect in Corporate Investment Decisions? Evidence from Real Estate Investment Trusts

“…These properties are then matched with firm characteristics, including performance and financial statement data. Specifically, we collect each firm's annual return, market capitalization (in 1996 dollars), Tobin's q ratio (defined as the market value of equity plus the book value of debt divided by total assets), 13 the fraction of the firm owned by insiders, and an indicator variable for firms that are Umbrella Partnership REITs (UPREITs). UPREITs are structures where the properties are owned by an operating partnership, which is in turn controlled and largely owned by the REIT.…”

“…13 In the context of real estate, one might argue that the book value of properties understates the true value due to book depreciation. Our results are robust to alternatively calculating q after adding back accumulated depreciation.…”