Follow the link for a great article by Richard Bahn of the Cato Institute called “Inflation and the Tax Man”
The fact that capital gains are not indexed for inflation has always irritated me. Now that Rudi Giuliani (who I’m not necessarily in favor of) has made this part of his tax proposals, the idea has gotten a lot more press. Here’s an excerpt from the article:
Assume you purchased a common stock in a company in 1984 for $100 a share and sold it in 2007 for $200 a share. Have you received any “income” from the sale of the shares of stock? The IRS would say “yes,” but this is clearly wrong. The IRS will claim that you had a $100 per share capital gain on the stock in the above example, yet actually the increase was solely a result of inflation. Because you cannot buy more goods and services with $200 now than you could have with $100 in 1984, you have had no “income” or wealth accretion.
The debate centers on the definition of income. The 16th Amendment to the Constitution states, “The Congress shall have the power to lay and collect taxes on incomes,” and the Fifth Amendment clearly states, “No person shall . . . be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use without just compensation.”
If the portion of a capital gain due solely to inflation is not income, then taxation without inflation-indexing is an unconstitutional taking of property. Income is commonly defined as, “the amount of money or its equivalent received during a period of time in exchange for labor or services from the sale of goods or property, or as profit from financial investments.”
It is not likely that many judges or members of Congress would find it in their personal, political, or the national interest to argue that phantom gains are “income.” After all, most Americans do understand the meaning of income, even if some in Washington do not.
This would make for an interesting Supreme Court case. Chances are, the only way the IRS would find out you were indexing your capital gains for inflation is if you told them in a note on your return. I could be mistaken but I don’t think Schedule D audits are very common… after a few years, nobody has any idea what their basis is in anything.