Legislative proposals to change the taxation of capital gains

Prior to the 2020 election, candidate Joseph Biden proposed significant changes to the taxation of capital gain income. Pronouncements from the Biden campaign had been to tax long-term capital gain income at the same rates of tax as ordinary income and to change the terms of the stepped-up basis.

In late May of this year, a document titled “General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals” (commonly referred to as the Green Book) was published. This presents proposed tax law changes in broad terms and has not been acted upon by Congress. The Green Book presents dozens of tax proposals and proposed changes to the taxation of capital gain income.

Many assets, including residential and business real estate, ownership in family businesses and investment assets such as stocks, might increase in value through time. Increases in value can comprise a significant portion of the net wealth of individuals. When these assets are sold, the gain is referred to as capital gain.

When a capital asset has been owned for more than a year, the gain on sale is long-term capital gain and has been taxed at lower rates than the top federal tax rate of 37%. The highest capital gain rate has been 20% for many years, with an additional 3.8% Medicare tax for high income taxpayers. Many taxpayers experience a lower federal tax rate on long-term capital gain as there also are rates of 0% and 15%, depending on the taxable income of the individual.

Biden proposed in his campaign to tax long-term capital gain income at the same rates of tax as ordinary income. The Green Book proposals provide more detail and go further. Capital gains income would be taxed at ordinary income tax rates of up to 39.6% plus 3.8% Medicare tax rate for a top rate of 43.4%.

Additionally, the Green Book proposes monumental changes to tax rules around stepped-up basis. Under current law, the tax cost of an asset (referred to as tax basis) is adjusted to the fair market value at the time of death. While this phenomenon is labeled as the stepped-up basis, it also can result in a step-down in basis if the property has decreased in value.

Stepped-up basis applies only to deathtime transfers. In the case of transfers by lifetime gift, the giver’s basis transfers to the recipient and this is referred to as carryover basis.

For example, assume an individual’s mother passed away, leaving real estate worth $500,000 at her passing that had a purchase price to the mother of $100,000. Under current law, the recipient’s tax basis of the property to her heirs is the date of death value of $500,000. If the property is later sold for $550,000, the taxable capital gain on the property is $50,000.

There are at least four reasons for the preferential tax rate on capital gains and/or the stepped-up basis.

First, the gain in value might result from inflation during many years and might not be true economic income. Second, complete tax basis records could be incomplete and difficult to determine after many years or decades of ownership. Third, stepped-up basis often is justified in that the property has been included in the deceased person’s estate and might have been subject to estate tax. Fourth and perhaps most importantly, both the preferential tax rate and stepped-up basis are tax incentives for long-term investments in capital assets.

The Green Book proposes that transfer by gift or bequest will be treated as a sale of the property at its value. There are exclusions that reduce the effect of these proposals for taxpayers with less than $1,000,000 of income or $1,000,000 in appreciation in assets at deathtime.

Many are concerned of the effect of these proposed tax law changes. The biggest concern relates to the decreased incentive for investment in residential and business real estate and other capital assets.

The federal tax rate on this income can be nearly double the rate under prior tax law. The deemed sale resulting from the gift or deathtime transfer would be a wholly new tax from prior tax law. The asset might need to be sold to fund the tax and there can be costly and time-consuming litigation about the value of an asset at gift or death.

We cannot be sure of the chance that these provisions will be enacted and the effective date of the provisions, but we will continue to monitor the congressional progress of these proposals. We believe that individuals should review their holdings and strategies to mitigate these proposed tax changes.