As you may know, President Biden proposes changing the tax law in a bunch of areas, including ratcheting up the capital gains tax that some investors pay on windfall gains.
Right now? Well, unfortunately, you and I can’t know what will happen. Mr. Biden can propose whatever he wants. But Congress passes legislation. And then Mr. Biden later signs that.
Nevertheless, some investors want to think now about possible Biden capital gains taxes. Forethought and some smart planning may allow these taxpayers to avoid paying the higher taxes.
But let’s go over the proposal. And then look at an example situation.
Biden Capital Gains Tax Explained
The Biden Capital Gains tax proposal appears in Mr. Biden’s American Families Plan. And the proposal works pretty simply. So, I’m going to quote it here:
Households making over $1 million—the top 0.3 percent of all households—will pay the same 39.6 percent rate on all their income, equalizing the rate paid on investment returns and wages.
One clarification. The top federal tax rate people pay today equals 37%. So, to be nitpicky, two tax law changes occur.
First, Mr. Biden proposes increasing the top tax rate on ordinary income from 37% to 39.6%.
Second, Mr. Biden proposes that for taxpayers receiving more than $1 million in income, that 39.6% applies not just to ordinary income (wages, interest income, pensions, and so forth). The 39.6% also applies to long-term capital gains and qualified dividends.
This useful reminder. Under current law, the highest federal tax rate these taxpayers pay on long-term capital gains and qualified dividends equals 20%.
Note: Most people pay a 0% tax rate on long-term capital gains and qualified dividends. (And most people for the record realize very little long-term capital gain or qualified dividend income.) And then everybody else pays a 15% tax rate.
Example of Biden Capital Gain Tax
In any case, there you see the proposal. Instead of paying 20%, someone with a very high income or with a once-in-a-blue-moon windfall might pay 39.6%.
Keeping the numbers simple, for example, say some entrepreneur earns $1,000,000 in wages and can sell her business for a $10,000,000 capital gain…
Under current tax law, she pays probably $2 million in federal capital gains tax.
Under the proposed tax law, she pays $3,960,000 in capital gains tax. Nearly double.
Note: Typically an investor also pays the 3.8% net investment income tax on these gains, though that isn’t always the case. But you can ignore this other tax for purposes of this discussion. The net investment income tax calculations work the same way under the current and the proposed tax laws.
Looking at the Return on Investment of Tax Gain Harvesting
People don’t like to pay taxes earlier. The usual advice suggests delaying. But you can calculate the return on investment a taxpayer generates by paying a small amount today instead of a larger amount tomorrow.
For example, you can calculate the investment return someone earns by paying $2,000,000 in taxes today to avoid paying $3,960,000 in taxes in a year, or in two years and so on.
The table below shows examples of this math for the proposed Biden capital gains tax:
|Sell one year early?||98%|
|Sell two years early?||41%|
|Sell three years early?||26%|
|Sell four years early?||19%|
|Sell five years early?||15%|
Those are very generous returns. And again note the percentages represent after-tax returns. Wow.
Taxpayers sitting on big unrealized capital gains probably want to think about paying the taxes now when possibly the rates equal 20% rather than later when rates may equal nearly 40%.
First, we don’t know whether Mr. Biden’s proposal will actually become law. And even if legislation reflecting his policy proposals become actual law, we don’t know when. Or the final details. Nevertheless, investors planning to realize big capital gains want to mull over the proposal and the benefits of tax gain harvesting. And soon, probably.
Second, and related, tax deferral tactics like Section 1031 exchanges need to be reconsidered if those tactics mean a taxpayer risks paying a future capital gains rate that’s double the current rate.
Third, the American Families plan also proposes eliminating the Section 1014 step-up in basis for some of the taxpayers who might be impacted by the Biden capital gains tax proposal. That proposed tax law change creates lots of additional complexity. For example, some taxpayers (like farmers and family business owners) may still benefit from the Section 1014 step-up. Accordingly, taxpayers and their advisors need to think carefully about assets that end up in a taxpayer’s estate.
Fourth, to be accurate. someone also wants to include the costs of any state-level capital gains taxes. If a state levies a 5% capital gains tax, for example, the choice an investor faces isn’t 20% today versus nearly 40% next year. Rather, the investor faces a choice between 25% today versus nearly 45% tomorrow.
The full text of American Families Plan: click here.
Washington state residents and investors should make sure they understand the new Washing state capital gains tax. That new law, which becomes effective starting in 2022, taxes capital gains in excess of $250,000 at 7 percent. More information here: Washington state capital taxes tax.