President Biden’s Proposed Capital Gains Taxes

In April of this year, the Biden Administration outlined their proposed framework for The American Families Plan, a combination of programs to help families with income and education along with new capital gains taxes.  At this point, the American Families Plan is a proposal that has not been passed by Congress and may either be different when it is passed or not passed at all.  However, the changes to capital gains taxes are significant enough that we should start planning for the possibilities now.

The proposed changes are relatively simple in nature but would open up complex strategies to avoid the new taxes for investors.  There are four basic changes being proposed.

1. Increase the ordinary income rate for the highest tax bracket from 37% to 39.6%.  This rate was reduced to 37% by the 2017 Trump tax cuts, and 39.6% is the old rate that existed before 2017.  This tax rate applies to ordinary income (not long-term capital gains and qualified income) on taxable income over $628,300 for married filers and $523,600 for single filers.

2. Tax long-term capital gains and qualified dividends at the ordinary income rate for income over $1 million per year.  The current long-term capital gains rate (assets held for over one year) ranges from 0% to 20%, depending on the amount of income a household has.  For a married couple with taxable income under $81,050, their capital gains rate is 0%.  If their taxable income is between $81,050 and $628,300, their capital gains rate is 15%.  If their income is over that range, their capital gains rate is 20%.  This provision would nearly double the capital gains rate from 20% to 39.6% for households with income over $1 million.

3. End the step-up in basis rules and tax unrealized gains at death. This provision comes with a $1 million exemption, but dying with assets that have appreciated more than $1 million would lead to a capital gains tax at death.  Furthermore, if the amount of those taxable gains after the exemption is more than $1 million, they would be subject to the new higher tax rates.

4. Taxing the gains of appreciated assets gifted during your lifetime.  The tax on these unrealized gains would apply in the year of the gift.  The $1 million lifetime exclusion applies here too.  However, it is the same exclusion allowed at death, so any lifetime gifts would reduce the exclusion remaining at death.

   
   

A part of the tax code that would not be affected, but is still relevant to the discussion, is the Net Investment Income Tax (NIIT) which applies a surtax of 3.8% to any investment income for single households with more than $200,000 of income and married households over $250,000 of income.  With this surtax in place, there really isn’t a 20% capital gains tax bracket because anyone in that bracket is already subject to the 3.8% surtax.  The effective capital gains tax rates are really 0%, 15%, 18.8%, and 23.8%.  This means that taxpayers with over $1 million in income would pay a rate of 43.4% (39.6% + 3.8%).

First, the good news, very few people will fall into this higher tax bracket for capital gains.  It is estimated that this will only affect the top 3/10 of 1% of American households.  The bad news is that it is possible that even though your income is well below a million dollars per year, you could have one year in which your “income” rises to that level when you sell an asset that has appreciated over decades, such as a business or farmland.  Even those who have appreciated assets that hold them may be subject to these taxes when they die.

So, what can be done to avoid or minimize the possible new capital gains tax rates?  There are a few strategies to consider.

1. Accelerate capital gains in 2021.  The proposal from the President includes the provision that these new tax rates would apply to any sales made after the announcement of the plan in April 2021.  However, with slim majorities in the House and Senate, the final result will likely have a start date of Jan 1, 2022.  If you are retiring and selling a business or farm, this may be the year to do it.  These can be complex transactions that take time, so starting now and watching the progress in Congress could end up saving you a large tax bill.

2. Spread out gains over multiple years.  This is the easiest strategy that applies to the greatest number of people.  Keeping your income under $1 million isn’t too hard for most taxpayers. Still, it may serve you well to voluntarily take gains each year while staying under $1 million per year to avoid having it all taxed at death if the amount of gain is over $1 million.  Suppose you are selling a business or real estate property. In that case, you should consider an installment sale on which you hold a note to the buyer and you spread out the capital gains over multiple tax years as the note gets paid down.

3. Use losses to offset gains.  A well-diversified portfolio is sure to have a position or two that are lower than when you bought it.  Selling shares of the positions with losses will offset gains that are taken in the same year.

4. Gift appreciated assets to charity.  Assets given to charity avoid the capital gains taxes and come with a charitable deduction equal to the asset’s value.  This is one of the best tax strategies available.  If you don’t have specific charities or dollar amounts in mind, you can make the donation to a Donor-Advised Fund that lets you distribute the donated funds over multiple years while taking the charitable deduction in the year of the contribution to the fund.

5. Make sure your estate plan is set up with taxes in mind.  If charities are part of your estate plan, giving the right assets to charities upon death while saving other assets for your family can make a large difference in overall taxes paid.  This is already the case and will only be amplified if these changes are passed.

   
   

I usually reserve tax planning advice until after the legislation is passed because the final version often looks a lot different from the original.  In this case, I think it is important to start planning now and to be flexible as we watch the process unfold.  As your advisors, we will be bringing specific planning opportunities to you on an individual basis.