The proposals put before congress concerning Capital Gains Taxes have been confusing for many, even financial professionals. Here, we'll discuss some of them so that you know what to watch for as these bills move forward.
If you don't know what these taxes are exactly, you're in the right place. We'll cover that too.
Capital gains taxes are not found inside of your IRA.
They are not inside your 401k.
They are not inside your Roth.
Capital gains taxes are found inside of accounts called “unqualified accounts.”
Unqualified just means that they aren’t your 401k or IRA accounts.
A capital gain can be defined as the profit you gain from selling things like investments, a business, or other assets like cars, boats, and real estate.
You will always buy something for a set price.
If you buy an asset for $100, that is considered your basis. If you hold onto that asset for a certain period of time, then you sell it for $150, now you have a $50 capital gain because you sold it for $50 above your basis.
This capital gain is taxable on your tax return.
Not the full $150 but just the $50 gain. If you held that asset for more than a year, current tax law sets the capital gains tax rates at 0, 15, or 20%.
The capital gains tables from 2021 show that if your total taxable income is $40,400 or less, you fall into the 0% bracket. If your income is $40,401 to $445,850 you fall in the 15% bracket. Above that income level, your rate climbs to 20%.
Capital gains tax rates have historically stayed lower than other tax rates because, keeping them low encourages investments. This is good for the economy. This encourages people to buy stuff, to create stuff, and to invest in businesses.
Now, one of the ways that President Biden is currently trying to raise tax revenue for his “American Families Plan” is by changing the Capital Gains Tax structure.
Michael Cohn from Accounting Today, says that this new plan:
“...would tax long-term capital gains and qualified dividends of taxpayers with adjusted gross income of more than $1 million at ordinary income tax rates. Under the proposal, 37% would generally be the highest individual tax rate (or 40.8%, including the net investment income tax), but only if the taxpayer’s income exceeded $1 million (or $500,000 for taxpayers who are married filing separately), indexed for inflation after 2022. The Green Book said the 'proposal would be effective for gains required to be recognized after the date of announcement.' However, that announcement could be interpreted as the date when the American Families Plan was first announced, on April 28.”
Okay, so what does all of that mean?
That means any couple that makes at least $1 million or anyone filing separately who makes $500k a year will have a jump in capital gains taxes to 39.6%, if the proposal becomes law.
To most people, this isn’t a huge deal.
The majority of Americans wouldn’t fall into this income bracket, so they may shrug and move on because, with that kind of money, what's a little more tax? However, that doesn’t actually mean the rest of us will be unaffected by the other proposed changes if they became law.
Another caveat with this proposal is that they are attempting to eliminate the step-up in basis for these assets.
In the past, if someone had a highly appreciated asset, rather than pay capital gains taxes, they would simply hold onto it until they die, and then pass it on to their heirs. Once it was passed on, there would be a step-up valuation done and the price it was worth on the day it changed hands would be the new “purchase price.”
For example, if your mother invested in Apple stock very early on, and then it had a huge appreciation, she could hold onto that and pass it on to you. Then, your basis would be the value of the stock on the date of her death. So, if you sold the stock on the day you inherited it, you'd have zero capital gains because of the new basis.
Now, how could this affect you? If a person is in the middle class or lower class and they inherit an asset worth over a million dollars, they would be affected by removing the step-up basis part of the law.
Here's another example:
There's an elderly person in New York City who passes away.
He bought a home for $80,000 many years ago, and as it currently stands, his heir would be able to have a new base price for that asset on the day of their parents’ death.
Rather than the original $80,000 that the parent spent, the child’s basis would be 5 million dollars. Then, when the child sold the home for $5 million, they wouldn’t owe any capital gains taxes.
Under the proposed changes, the basis wouldn’t step-up upon death. The child would inherit the home as well as the base of $80,000. If the child sold the home, there would be capital gains taxes on $4,920,000 minus the first million dollars.
Many people shrug this added taxation off. I've heard comments like, “You’ll be left with plenty of money that you wouldn’t have been getting otherwise and you’re still way ahead- even with all the taxes! Just be grateful for what's left after taxes and move on.”
But... it gets worse.
According to ThinkAdvisor’s Robert Bloink and William H. Byrnes, “In a surprise move, any unrealized asset appreciation would trigger taxation on the date of the original owner’s death — regardless of whether the beneficiary actually sold the property.”
This means, there is also a proposal to tax unrealized capital gains at death. The leaders in government would like to make death a recognizable event.
What does that mean?
Well, right now, death is not considered a “sale” which is a recognizable event for capital gains taxes to kick in. But, this proposal would mean that the transfer upon death becomes a “sale.”
Consider a scenario where a child, who stands to inherit property, has always lived with their parent. When the parent dies, and the ownership of the house is transferred upon death, the full amount of unrealized capital gains taxes (for example the taxes on that $4,920,000) would be due whether the house was sold or not.
How many people could come up with the money for that tax bill if they wanted to keep the family home without selling it? How long would it take to sell the home? How quickly would the taxes be due?
The final part of this proposal was stated in the earlier quote from Michael Cohn. If you remember he said, “The 'proposal would be effective for gains required to be recognized after the date of announcement.”
There hasn't been a clear understanding of what date this proposal is talking about.
This means that no one knows when the provisions in the bill would take effect. If they make it a retroactive date, it would be in an attempt to close any loophole for someone with a large asset to decide to sell it under our current capital gain tax law.
There is certainly a lot to consider with these current proposals and a lot we still don’t know.
One hopeful thought on all of this is, the proposal still has to gain enough votes in congress to become law.
So, we don’t know what is coming in that regard. However, if you stand to gain or plan to leave a sizable inheritance, you may want to meet with a tax professional and discuss your options as soon as possible.
However, even tax advisors aren’t certain which way things will go right now. This is certainly something that we all should keep an eye on as congress begins the process of voting on these issues.
I’ll certainly be watching this closely and updating as we learn more.