Are higher capital gains taxes ahead?

Jun 02, 2021 - 5 Min read
Peter Miller
Real Estate Expert

A new tax idea is floating around Washington, one unlikely to thrill real estate investors.

The Biden Administration is considering a proposal to increase the long-term capital gains rate to as much as 39.6% for those earning at least $1 million. That percentage, plus a 3.8% tax on investment income, could mean a long-term capital gains tax of as much as 43.4%.

An increased capital gains rate is part of a general tax reform package now taking shape in DC.

For a very long time the way we tax wages has been very different from the way we tax capital gains. The rates can be different plus those who earn wages generally pay income taxes as well as taxes for Social Security and Medicare.

“At least 55 of the largest corporations in America paid no federal corporate income taxes in their most recent fiscal year despite enjoying substantial pretax profits in the United States,” said the Institute on Taxation and Economic Policy (ITEP) in a just-issued report. 

ITEP also explained that “the tax-avoiding companies represent various industries and collectively enjoyed almost $40.5 billion in U.S. pretax income in 2020, according to their annual financial reports. The statutory federal tax rate for corporate profits is 21 percent. The 55 corporations would have paid a collective total of $8.5 billion for the year had they paid that rate on their 2020 income. Instead, they received $3.5 billion in tax rebates.”

Tax reform 2021

The Biden Administration plainly wants to reform the tax system, especially the Trump Administration’s 2017 Tax Cuts and Jobs Act. Prime targets will no doubt be the 21% corporate tax rate as well as the $10,000 limit on state and local taxes, the SALT deductions.

In addition, the long-term capital gains tax is increasingly mentioned. Whether a proposal to raise this tax will gain traction in the House and Senate is unclear.

In basic terms, the long-term capital gains tax applies to the sale of assets held more than a year. The rate schedule is a convoluted mix of percentages and income levels. For instance, the IRS explains that “a capital gain rate of 15% applies if your taxable income is $80,000 or more but less than $441,450 for single; $496,600 for married filing jointly or qualifying widow(er); $469,050 for head of household, or $248,300 for married filing separately.”

It adds that “a net capital gain tax rate of 20% applies to the extent that your taxable income exceeds the thresholds set for the15% capital gain rate.”

There are other rates and conditions as well, speak with a tax professional for details

Targeting the rich

If passed, a 39.6% tax rate would essentially double the capital gains tax now paid by those making more than $1 million per year. However, the story for those earning less would likely be different. White House Press Secretary Jen Psaki says people making under $400,000 a year “will not have their taxes go up.”

Brian Deese, director of the National Economic Council, points out that those reporting $1 million in income per year represent just 500,000 households nationwide. Also, in 2020, among the top of the top, some 1,400 households reported annual incomes of $60 million or more.

“The principle here,” said Deese, “is to equalize the treatment of ordinary income and capital gains, and that is a principle that’s neither new nor particularly novel. In fact, the last President to enact a reform to equalize the treatment of ordinary income and capital gains was President Reagan, who did so while raising capital gains taxes as part of the 1986 Tax Reform.”

Can a higher capital gain tax pass Congress?

“At this point,” said Rick Sharga, RealtyTrac‘s Executive Vice President, “the Biden capital gains proposal is simply a trial balloon. A new tax package must pass Congress and the Biden plan, whatever its details and fine print, is unlikely to gain traction without modifications.”

Phantom profits

One central problem with the capital gains tax is that the current approach taxes phantom profits. Here’s how:

The Smiths bought an investment property for $200,000 in 2005. They just sold the property for $425,000. It appears on a cash basis they have a $225,000 capital gain and thus face a federal capital gain tax bill of at least $33,750 ($225,000 x 15%). In the end they appear to keep $191,250 ($225,000 less $33,750)

But the dollars the Smiths retain are suspect. They don’t have the same buying power as yummy 2005 cash. Correcting for inflation, you need $277,794 in 2021 to buy the same goods and services that $200,000 purchased in 2005. A big chunk of the Smiths’ “profit” does not buy more stuff, it does not create additional buying power or wealth, and yet it’s taxed. Adjust the acquisition price for inflation and the tax picture changes. Smith would now have a purchase price of $277,794, a sale price of $425,000, and a corrected profit of $147,206

State taxes

The capital gains fight may not be limited to Capital Hill. Washington state, home to the massive Seattle-area tech community, has just passed a 7% capital gains tax. Other states might follow suit in the eternal hunt for additional funding.

Gradual change?

A quickie boost for the capital gains rate changes the rules of the game well after the players are on the field. The capital gains tax rate in 2005 was 15% for most property owners. That rate was part of the Smith’s investment calculation. Raise the rate, and it may be that a number of Smiths will do something else with their money. That can mean fewer rental units and thus higher rents, not the social good everyone wants. Rather than a sudden rate increase, the alternative option might be to raise capital gains taxes gradually.

Given the slim Democratic majority in the House and Senate, some capital gains adjustments seem possible but not as much as the Biden plan may suggest. Certainly the new rate, if there is a new rate, will be nowhere near the historic maximum, a 77% rate in place during the early 1920s according to the Tax Foundation.

Meanwhile, the real real targets of the new tax initiative are plainly visible, those 500,000 households in the upper-most of the upper brackets. Such targeting is important because tax policy – as always – is firmly-based on strong political support favoring higher rates for someone else.

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