If you have more than $1 million in capital gains you may be considering realizing those gains this year. That’s because President Joe Biden is expected to release The American Families Plan which includes a provision to almost double the capital gains tax rate for those earning in excess of $1 million per year.
After the news broke the Dow Jones Industrial Average dropped more than 300 points with market fears of an increased capital gains tax on investors; the question on everyone’s mind being – to sell or not to sell?
With the 2020 tax filing season still in full force and questions surrounding what the tax rate might look like in 2021, you might be contemplating realizing capital gains sooner rather than later to avoid the tax hit in 2022 and beyond. However, if you’re an investor should you be running for the door? If you sold your business in 2020 and 2021 should you forego an instalment sale? If you invest in real estate should you reconsider deferring capital gains by investing in Qualified Opportunity Zones?
As of now it’s unclear if Democrats can pass these proposals through the slim majority in the House and Senate, however, with millions of dollars in tax at stake it’s important to discuss the likelihood and potential impact of a capital gains tax hike.
What’s the Odds of This Passing?
If you were closely following then presidential candidate Joe Biden’s tax proposals it would come as no surprise to you that raising the capital gains tax rate would be one of the centerpieces of his policy initiatives. On the campaign trail, Mr. Biden did not have a comprehensive tax agenda but instead spoke of proposed tax increases as a way of paying for new spending programs.
For example, the latest infrastructure plan would be paid for, in part, by an increase in the corporate tax rate. Likewise, this latest proposal would use an increase in the capital gains tax rate to pay for childcare and universal paid family leave. The spending and the tax increases come as a package deal unlike previous tax legislation like the Tax Cuts and Jobs Act (TCJA) passed by the Republicans in 2017.
Given this interplay, it’s unlikely that any Republican would vote for new spending programs after passing more than $5 trillion in Covid relief this past year. Even more so, the odds of a single Republican attaching his or her name to a tax increase of this magnitude would be near zero. Therefore, there are only one of two ways this tax increase can become law.
The budget reconciliation process allows lawmakers to sidestep the Senate filibuster and expedite consideration of certain tax, spending, and debt limit legislation with a simple majority. Generally, this power is limited and can only be used once per fiscal year. Democrats already used the process to pass the American Rescue Plan so the next time they can use it is for fiscal year 2022 (which begins on October 1, 2021).
Eliminating the Filibuster in the Senate would allow Democrats to pass legislation with a simple majority but it would require the vote of every single Democratic Senator. Senator Joe Manchin (D-W.Va.) has publicly come out against any proposal that would change the filibuster.
So what are the odds of a capital gains tax increase passing? Given the tight majority in the House and the Senate and the unlikelihood of filibuster reform it is highly unlikely that the capital gains tax would almost double retroactively as of January 1, 2021. However, we’ve seen crazier events unfold over the past year so we can’t rule anything out. More likely, though, if the Democrats are able to pass an increase in the capital gains tax rates after October 1, 2021, it would take effect with prospectively, as of January 1, 2022.
Tax Planning Strategies
If you think a capital gains hike is inevitable then there are several tax strategies to consider.
Tax-loss harvesting is a great way to reduce taxable capital gains especially if you expect rates to go up. Tax-loss harvesting works by selling investments that are down, replacing them with similar investments that do not trigger the wash sale rule, and then offset recognized investment gains with those losses. This amounts to kicking the can down the road but hopefully the road leads to a tax year when capital gain tax rates are lower. It’s never too early to start thinking about harvesting tax losses especially since losses can occur throughout the year.
Accelerating Capital Gains
Although tax rates on capital gains may become retroactive to the beginning of the year it is unlikely that Congress would penalize taxpayers who expected a 20% rate only to have Congress move the goal post at the end of the year. If you expect capital gains to increase in 2022, and not in 2021, then it may be a good idea to accelerate some capital gains into 2021. If you’re looking to cash out on an investment that has done well or sell your business before the end of the year, then now is the time to start planning.
Pass on Installment Sales
An installment sale allows taxpayers to defer capital gains until the cash from the sale is actually received. For example, if you sold your business in 2020 but will be paid out over five years then you can recognize the gain proportionately over five years. However, if you really think capital gains tax rates will go up in 2021 or 2022 then electing out of instalment sale treatment and paying the tax upfront may be an option.
Section 1202 Qualified Small Business Stock
Section 1202 rewards investors who invest money into startup companies by allowing them to exclude some or all of the gain from the sale of qualified small business stock (QSBS). Gain from the sale of QSBS acquired after Sept. 27, 2010 and held for more than five years is eligible for a 100% exclusion of up to the greater of $10 million or ten times basis. This means that even if rates on capital gain tax rates goes up QSBS investors can avoid the tax entirely.
Qualified Opportunity Zones
If you invested capital gain in a qualified opportunity fund (QOF) then you know you have deferral of such gain until December 31, 2026. Should you sell that investment and trigger the gain now before rates go up, or wait it out until the next administration? There is no telling what the world or capital gains tax rates will look like in 2025 or 2026; however, prematurely pulling out funds in a QOF can end the party before it’s even begun. If you can stick it out for 10 years then that QOF investment can be sold tax free. If you think rates will be higher next year then you probably don’t think they will be any better 10 years from now.
Think Before You Act
Before rushing to make any major investment decision based on policy proposals or news headlines you should talk it through with you tax or financial advisor. Tax rates will eventually go up, so it’s important to craft an intelligent tax strategy going forward. Odds are if you are sitting on a few million in unrealized capital gains you are good at making predictions; so what’s the answer – to sell or not to sell?
reach out to a Withum business tax services member.
Biden’s Tax Policy