With all the talk these days about potential changes to capital gains taxes, let’s take a step back and explore what capital gains are and how they’re currently taxed to better understand what related tax law changes could mean for you.
What are capital gains?
You have an investment – a capital asset. Maybe it’s ownership in a business. Maybe it’s precious metals or cryptocurrency. Maybe it’s your home. I’d give you a definition of exactly what is considered a capital asset from a tax perspective, but for the fact that the Internal Revenue Code doesn’t define this very important term. Shocking, right? Instead, it only tells you what a capital asset is not1. For your purposes, assume the investment you’re holding is indeed a capital asset subject to capital gains tax treatment unless your tax advisor has informed you otherwise.
Your hope is that the value of your investment will increase over time, perhaps even that one day you’ll be able to cash it in (sales proceeds) for more than you put into it (cost basis). You bought one share of Home Depot stock when it was trading at $100 per share and now it’s trading at $330 per share. This increase of $230 is capital gain, specifically it’s unrealized capital gain. Only when you sell the share, do you have a realized capital gain. Unrealized gains typically are not subject to tax, while realized gains may or may not be subject to tax. If a realized gain is subject to tax, we say that it’s a recognized gain. Understanding these three variations of capital gains is important to understanding how your financial decisions impact your taxes. You’ll also see these terms used as you read further here and elsewhere, so let’s take a quick dive in to better understand them.
In the Home Depot example, it’s quite possible that your realized and recognized gain are the same. Let’s look at a scenario where this is not the case. You and your spouse purchased your primary residence four years ago for $450,000 and now it’s worth $700,000. The $350,000 increase is unrealized gain because you haven’t yet sold the house. You then sell the house and pocket the profit; now you have $350,000 of realized gain. Your recognized gain – the amount subject to tax – is $0. Why? Because there is a very specific tax law on the books that excludes this realized gain from being considered taxable2. Sell Home Depot stock, probably pay tax. Sell your home, probably don’t pay tax. Easy peasy, right?
Note that this works similarly for capital losses. If your investment has decreased in value, you have an unrealized capital loss. If you sell that investment, you have a realized capital loss. Depending on all kinds of facts related to the transaction and your overall tax situation, you may or may not have a capital loss that can provide a tax benefit. For example, you buy a new family car for $35,000. You have an endearing, naïve hope that the car will hold its value, yet it does not. You decide to sell the car six years later when it is worth $15,000. Although you will realize a $20,000 loss on the sale, your recognized loss is $0 because there is generally no tax benefit available for selling a personal-use vehicle.
How are capital gains currently taxed?
It depends. Of course. You knew that answer was coming.
You’ve likely heard that the current federal capital gains rate is 15% which often ends up being lower than tax rates on ordinary income such as wages, self-employed earnings, interest income, distributions from retirement account, etc. While saying capital gains are taxed at 15% isn’t untrue, this quick explanation leaves out so much information that it is unhelpful for most situations.
You should also know:
- Capital gains aren’t taxed at just one rate. They’re subject to three rates: 0%, 15% and 20% based on your overall income level for the year. For 2021, the federal capital gains rate is 0% if your taxable income is under around $80,000, 15% for taxable income from about $80,000-$500,000, and 20% once you hit around $500,0003. This is important to consider – for example, are you trying to avoid a transaction you won’t be taxed on because your overall income isn’t high enough? Could you shift realizing & recognizing gains across years to reduce overall capital gains tax exposure?
- Holding period matters. If you hold (own) the asset for more than a year leading up to its sale, you’ll likely receive long-term capital gain treatment. If you’ve held the asset a year or less when you sell, then you likely will not. Instead, this short-term gain is taxed at ordinary income tax rates.
- For taxpayers with over $250,000 of income for the year, the federal Net Investment Income tax of 3.8% applies to most long-term capital gain transactions, as well as other types of investment income, such as interest and royalties. Now that 15% is looking more like 18.8% and 20% is now 23.8%.
- Some types of investments, while still considered capital assets, are subject to higher federal capital gains tax rates. For example, collectibles such as fine art and precious metals are subject to a flat 28% capital gains tax. A portion of the gain on the sale of rental real estate related to previously claimed depreciation can be taxed at a flat 25%. Again, the Net Investment Income tax of 3.8% may also apply depending on your income level for the year.
- Gains and losses are netted annually. Recognized capital gains and recognized capital losses are netted against each other for the tax year. The result is either a net capital gain or a net capital loss. Note that net capital losses can only be deducted up to $3,000 year with the remainder carrying forward to be part of the next year’s netting calculation. It’s important to note that capital losses for individual taxpayers are only carried forward, not carried back. Do your best to structure transactions so that big losses are in either the same years as big gains or in prior years. A year with a large net capital gain followed by a year with a large net capital loss is what tax professionals call “a bad answer.”
- State taxes can come into play. With exceptions, capital gains are typically taxed based on your state of domicile. Your home state may or may not tax capital gains. Further, a transaction that isn’t recognized for federal tax purposes may be recognized for state tax purposes and vice versa depending on the nature of the transaction, age of the taxpayer, etc. Don’t overlook state tax treatment for either additional taxes due or tax savings.
Some ways to minimize or avoid tax on capital gains
- Defer. You may be able to push capital gains off into a future year. This could create a permanent tax savings if you anticipate a lower tax rate for future year recognition. If you expect your tax situation and related tax law to be the same later down the road, you may at least be able to generate a time-value-of-money savings by making the transaction next year’s problem. Like-kind exchanges – a/k/a 1031 exchanges – are a long-standing tax strategy that allow the gain on certain real estate transactions to be partially or fully deferred. Qualified Opportunity Zones (QOZ) as created in the Tax Cuts and Jobs Act of 2017 allow investors to defer (potentially exclude) gains invested in QOZ funds until certain investment milestones are reached or until a specific amount of time has passed.
- Exclude. Reminder – not all gains are recognized. Again, gain on the sale of your primary residence is often excluded from tax. Another example is the exclusion of gain on the sale of certain small business stock4. Gains generated inside of a whole life policy or retirement account generally would not be included in an account owner’s income, although either type of account is often a landmine for other tax issues. Although not technically an exclusion, if you can lower your overall taxable income, you may be able to reduce your federal capital gains rate to 0% as discussed earlier.
- Offset. As discussed earlier, consider realizing capital losses in a way to allow for the offset of realized/recognized gains. Additionally, make sure that you’ve captured your entire investment in the activity that you’re selling. Put another way, you want your cost basis to be as high as possible to allow for a gain that’s as low as possible. For example, if you’re selling real estate, be sure to include your closing costs in the gain calculation.
- Donate. I love this one. Donating appreciated long-term capital assets to a 501(c)(3) charity has a double tax benefit that results in significant leverage. One on hand, the unrealized gain isn’t ever recognized. Simultaneously, you receive a charitable contribution deduction equivalent to the market value of the property on the date of donation. This is a much better move than selling the investment and donating the resulting cash as you’ll either a) have less after-tax funds to donate or b) need to sell more of your investment to yield the desired level of after-tax funds to donate. Additionally, establishing a Donor-Advised Fund is an excellent way to divorce the timing of the tax implication to you from when the organization(s) receives funding. You can receive a large charitable contribution in the current year, while making annual grants at lower levels over several years. I see this strategy regularly used for executives who are diversifying their employer stock-heavy portfolio. This also works well if you’re holding stock that you were gifted some time ago – perhaps as part of a family member’s estate plan – and it has relatively low basis compared to its market value. Speaking of…
- Gift. Typically, this would look like an older family member (donor) gifting appreciated assets to a younger family member (donee) as part of an income and/or estate tax strategy. In this move, a donee will typically receive carryover basis in such assets but will be in a lower tax bracket so better equipped to handle the recognized gain on sale and/or manage future appreciation. Gifting stocks, real estate, and other assets to family members can have significant, and often unintended, tax and legal implications. Such moves should not be made without consulting appropriate legal and tax advisors.
- Die. I saved the best for last, right? But in all seriousness, this is one of the more common ways I see clients avoid capital gains. Under current tax law, the cost bases of a deceased taxpayer’s assets are generally stepped to market value on date of death. Assuming increasing values over time, this is most often a step up. For example, your grandmother has one share of Apple stock that she bought forever ago for $20. If she sells it at its current market price of $125 per share, she will have a recognized gain of $105 on which she may owe capital gains tax depending on her overall tax situation. If instead, grandma dies (sorry!) and you inherit her share, a) the unrealized gain is magically gone forever and b) your cost basis in the share is the $125 market value on the date of grandma’s passing. $125 sale proceeds less $125 stepped-up basis = $0 gain. You’ll need to consult with appropriate legal and tax advisors to understand how assets you’ve inherited, or intend to leave to others, will be taxed.
After all the above and any other applicable ideas have been exhausted, then it’s a question of deciding when to realize & recognize capital gains by setting an annual capital gains budget. Such a budget will be influenced by the remainder of your tax situation, as well as potential tax law changes. Which leads us into the next section.
What changes are being proposed to capital gains taxes and what are the implications?
President Biden has proposed significant capital gains-related tax changes as part of the American Families Plan.
- Capital gain tax rate increase. Along with increasing the top ordinary income tax rate back to the Obama-era 39.6%, the top federal tax rate on capital gains would also be 39.6% for taxpayers with over $1,000,000 of income for the year. There are tons of questions about to whom – and how – this would actually apply. If you’re at all concerned this could be you, you’ll want to be positioned to realize capital gains before such law might take effect5 or, if you’re optimistic and patient, be prepared to sit on investments until the law could potentially change in your favor. You may also find yourself looking for ways to stay under the $1M income threshold.
- 1031 gain deferral reduction. 1031/like-kind exchanges mentioned earlier would be capped at $500,000 of gain deferral. I doubt this means larger exchanges wouldn’t be allowed, but only up to $500,000 of the gain could be excluded from recognition.
- Tax inherited unrealized gains. The President’s plan calls for one more change to capital gains taxes by going after the step-up basis rules. This section of the plan is hard to follow, but here’s my interpretation. This change would hit beneficiaries rather than the estate itself. Beneficiaries inheriting assets with unrealized gains over $1,000,0006 would not be allowed a step up. In other words, the beneficiaries would receive carryover basis as if they had been gifted the assets by the deceased. I know the basis step-up rules are seen as a ‘loophole.’ As someone who’s tried to help many clients over the years chase down a donor’s cost basis in gifting situations, I see the step-up rules as an administrative blessing. Additionally, if the gain to be taxed is unrealized, now we’re getting into valuation territory as there’s been no transaction to readily affirm the asset’s market value. This is relatively straightforward with publicly traded stock and even some real estate but can be challenging with less liquid assets such as small businesses. More heirs will be caught up in employing a host of legal and tax advisors to comply with all this.7
With stock market and real estate prices currently at crazy highs, the Executive branch is looking to turn some of that appreciation into more tax revenues. How would a sudden shift in capital gains taxation impact you? Perhaps you’ll rearrange transaction timing, redo your estate plan, etc. How would a sudden shift in capital gains taxation impact the markets and the economy? Will folks rush to sell in 2021 and/or HODLing8 for the next several years thereafter? The latter is beyond my scope to predict, but I can reasonably see a strong correlation between a) the number of taxpayers hit by capital gains tax changes and the extent to which they feel it, and b) the breadth of the impact felt by us all as many small moves add up.
Keep in mind that President Biden’s proposal is still just a proposal. Anything that makes it through the House and Senate before passing will look different, and it’s impossible to say exactly in what way it would differ. As we’ve seen over the last several years, federal tax laws are not stress-tested for unintended consequences before being passed, so a final bill could be a far cry from the proposal. Tread carefully.
As always, if you have any questions or concerns about how this matter could impact your tax situation, please feel free to reach out.
1 Internal Revenue Code Section 1221
2 Internal Revenue Code Section 121. There are several tests you must meet to ensure gain exclusion and, even then, you could have a partial gain exclusion. Your state may also tax this gain to some extent.
32021 capital gains brackets are for Married Filing Jointly filing status.
4 Internal Revenue Code Section 1202
5Assuming that it wouldn’t be retroactive back to 2021. We have seen some retroactive tax law changes recently, but it’s all been taxpayer-friendly. My best guess is the odds of something passing right now that is retroactively taxpayer-unfriendly are slim.
6Or $2.5M for a couple. The plan doesn’t mention why a couple would receive more than double the Single exclusion. Additionally, from the wording of the plan, it sounds as though there would be an exclusion for a certain level of real estate. I’ve seen other advisors interpret this section of the plan to mean that the $1M/$2.5M is related to the beneficiaries’ income, not to the gain itself. That would certainly be in keeping with the plan’s other tax-related language, but doesn’t actually seem to be how this particular section is worded.
7 I do realize there’s more to tax law than what is administratively convenient. However, it is an aspect of sound tax policy that I don’t see discussed much, so I wanted to give is some love here.
8Holding On for Dear Life. This phrase brought to you by the lovely folks hoping their crypto will go the moon.