President Biden’s proposal to increase the capital gains tax has generated tremendous discussion. Looking at this proposed change in the context of past changes shows that both Democratic and Republican presidents have signed legislation with retroactive tax provisions. A retroactive change may be hard to get through congress because capital gains rates have been consistently low for a while, but it is still possible an increase could take effect for all or part of 2021.
Let’s first look at the Biden Administration’s proposed changes, as explained in the recently released “Green Book”, the explanation of the Administration’s 2022 revenue proposals.
The American Families Plan has individual tax changes affecting higher-income taxpayers–an increase in the capital gains rate and the income taxation of appreciated property held at death or transferred by gift. Here are more details.
- Top Individual Rate: The top individual rate would be increased from 37% to 39.6% and would apply to those with taxable incomes in the top one percent. For the taxable year 2022, the top marginal tax rate would apply to taxable income over $509,300 for married individuals filing jointly and $452,700 for unmarried individuals.
- Capital Gains and Dividend Rates: Long-term capital gains and qualified dividends of taxpayers with adjusted gross income (AGI) of more than $1 million would be taxed at ordinary income tax rates of up to 39.6% but with a rate of 43.4% if you include the net investment income tax. This change would only apply to the extent that the taxpayer’s income exceeds $1 million. That income amount would be indexed for inflation after 2022.
Example: A taxpayer with $900,000 in labor income and $200,000 in capital gains would have $100,000 of capital gains taxed at the current preferential tax rate and $100,000 taxed at ordinary income tax rates.
Effective Date: The effective date would be retroactive to April 28, 2021, the date President Biden first unveiled his proposals. The Green Book says this: “This proposal would be effective for gains required to be recognized after the date of announcement.”
- Appreciated Assets Passed By Gift or Through an Estate. The proposal would treat transfers of appreciated property by gift or on death as realization events. The donor or deceased owner of an appreciated asset would realize a capital gain at the time of the transfer. This proposal effectively ends the income tax exclusion for appreciated assets passed through an estate.
Gifts: For a donor, the amount of the gain realized would be the excess of the asset’s fair market value on the date of the gift over the donor’s basis in that asset. Under current law, donors may pay the gift tax, but do not pay income tax on appreciated gifts.
Estates: For a decedent, the amount of gain would be the excess of the asset’s fair market value on the decedent’s date of death over the decedent’s basis in that asset. That gain would be taxable income to the decedent on the Federal gift or estate tax return or on a separate capital gains return. The use of capital losses and carryforwards would be allowed against capital gains income and up to $3,000 of ordinary income on the decedent’s final income tax return. The tax imposed on gains deemed realized at death would be deductible on the decedent’s estate tax return. The existing estate tax rules would not be changed.
Entity Gains. Gain on unrealized appreciation would be recognized by a trust, partnership, or other non-corporate entity that is the owner of the property if that property has not been the subject of a recognition event within the prior 90 years, with such testing period beginning on January 1, 1940. The first possible recognition event for any taxpayer under this provision would be December 31, 2030.
Exclusions: The proposal would allow the following exclusions:
- A $1 million per person exclusion, $2 million for married couples, of unrealized capital gains on property transferred by gift or held at death.
- Exclusion for any gain on tangible personal property such as household furnishings and personal effects (excluding collectibles).
- The $250,000 per person exclusion ($500,000 for married couples) under current law for capital gain on a principal residence would continue to apply.
- The exclusion under current law for capital gain on small business stock would continue to apply.
- Gains would not be taxed if estate property is donated to charity.
- Appreciated interests in family-owned businesses and farms will not be taxable if given to heirs who continue to run the business.
The proposal would allow a 15-year fixed-rate payment plan for the tax on appreciated assets transferred at death, other than liquid assets such as publicly traded financial assets. It also would allow a deduction for the full cost of appraisals of appreciated assets and waive certain penalties, like the estimated tax penalty.
To facilitate the transition to taxing gains at gift and upon death, the Treasury Secretary would be granted authority to issue regulations with rules and safe harbors for determining the basis of assets in cases where complete records are unavailable.
Effective Date: The estate and gift proposal would be effective for gains on property transferred by gift and on property owned at death by decedents dying after December 31, 2021.
Retroactivity is Possible
The Green Book specifically provides for a retroactive effective date for the capital gains tax increase. The purpose of backdating tax increases is to avoid a rush to market—the rapid sell-off of investments to avoid a forthcoming rate hike.
While some Democrats have expressed concern about a capital gains increase with a retroactive effective date, the ability of Congress to enact retroactive tax legislation has a legal basis. The Supreme Court unanimously upheld a retroactive increase in the estate tax rate in the 1994 case of United States v. Carlton. The Court developed a two-part test for determining whether retroactive application of a tax statute violates due process: (1) the statute must have a rational legislative purpose and not be arbitrary or irrational; and (2) the period of retroactivity must be modest, not excessive.
The capital gains increase presumably would be retroactive for less than a year. In addition, the Green Book gives the following explanation of the legislative purpose of the capital gains tax increase. “Preferential tax rates on long-term capital gains and qualified dividends disproportionately benefit high-income taxpayers and provide many high-income taxpayers with a lower tax rate than many low- and middle-income taxpayers. The rate disparity between ordinary income taxes and capital gains and dividends taxes also encourages economically wasteful efforts to convert labor income into capital income as a tax avoidance strategy.”
Given the Carlton reasoning, Biden’s plan is legally feasible. However, political support for retroactivity is unclear at this point. Top bank CEOs told a Congressional committee in May that a retroactive capital gains increase could scare investors and hurt the economic recovery. Some Democratic senators have already said they want to maintain some type of capital gains differential. Republicans are lined up to try to stop any changes to the 2017 Tax Cuts and Jobs Act. Conservative-leaning think tanks also are warning against capital gains tax increases.
Effect of Capital Gains Tax Increase
Whether or not the capital gains tax increase is retroactive, the effects on investing and tax planning could be dramatic. If the effective date is retroactive to April 2021, it will be too late for investors to sell to avoid the tax increase. Donors will be able to give gifts without realization if the estate provisions take effect after 2021, the stated effective date in the Green Book for the estate and gift provisions.
The Tax Foundation has observed that a higher capital gains tax rate would influence when taxpayers decide to sell assets and realize the gain and would encourage taxpayers to hold onto appreciated assets. The Penn Wharton Business Model finds that when taxes on capital gains increase, realizations of capital gains fall, and, therefore, government revenues could decrease. The Tax Policy Center found that capital gains realization increased by 60% before the capital gains tax was increased from 20% to 28% by the Tax Reform Act of 1986, effective in 1987, and by 40% in 2012, in anticipation of the increased maximum tax rate from 15% to 25% in 2013.
So, what does this mean for individual investors? If the capital gains tax rate is increased, taxpayers will have the incentive to more carefully time the realization of gains. Taxpayers may hold onto investments for longer periods of time. Taxpayers may time gains for a year when they have losses to offset gains or when they have income levels below the $1 million threshold.
If a capital gains increase is prospective, taking effect in 2022, taxpayers should consider sell-offs before the end of the year to take advantage of lower 2021 rates.
For estate planning purposes, holding onto appreciated assets to avoid income taxation would no longer work. Alternate strategies may be more beneficial. Tracking the basis of assets held a long time and passed through an estate may prove challenging. Presumably, the exclusion of tax on personal belongings should help and the Biden Administration has indicated that the Treasury will explore ways to deal with difficult basis issues.
While the opposition is significant, the Democrats can use the reconciliation process to pass tax legislation with a simple majority in the Senate, as the Republicans did to pass the TCJA. However, the Democrats will need every vote, and it appears that they may not have a solid consensus on the capital gains issue. Because any change to the capital gains rate could have a far-reaching effect on investments and the planning strategies investors use to minimize tax liability, the time to model changes for your personal portfolio is now, even if the chances of the legislation passing are slim. Your Frazier & Deeter tax professional can help you evaluate the possibilities.