Capital Gains Tax under the American Families Plan

Of the many proposals contained in the American Families Plan unveiled by the Biden Administration on April 28, 2021, an increase in the tax rate on long term capital gains income above $1 million is one of the most prominent. Suddenly, capital gains taxes are all over the news.

With a possible change in rates looming, now is a good time to review the complex and highly charged topic of income taxes on capital gains, especially as current proposals could affect some filers who may not expect it. Capital gains are the profits from the sale of an asset — shares of stock, a piece of land, a business — and generally are considered taxable income. How much these gains are taxed depends on the taxpayer’s holding period and the asset type. In 2020, and so far in 2021, the capital gain tax rates are 0%, 15% or 20% for most assets held for more than a year. This is referred to as a long-term gain. Capital gain tax rates on most assets held for less than a year correspond to ordinary income tax brackets (10%, 12%, 22%, 24%, 32%, 35% or 37%). Holdings of less than a year are known as short-term gains.

NOTE: These ordinary income tax rates are also proposed to change from 37% to 39.6%, which, when added to the 3.8% Medicare tax, would take the top ordinary income tax bracket to 43.4%.

Changes in Taxation of Capital Gains Income

While income and filing thresholds are not yet defined, a number of changes are proposed in the taxation of capital gains.

Increase highest long-term capital gain and qualified dividend rate

For taxpayers with adjusted gross income, or AGI (basically, all of a taxpayer’s income before deductions), of more than $1 million, long-term capital gains and qualified dividends would be taxed at an ordinary income tax rates – but only to the extent that the taxpayer’s income exceeds $1 million ($500,000 for those filing married/separate.)

EXAMPLE

T, a single individual filer, has $900,000 in wages and $200,000 in long-term capital gains (LTCG) from selling stock investments. T has no other income or adjustments, and her AGI is $1.1 million. Under the proposal, $100,000 of LTCG would be taxed at the preferential capital gain rates and $100,000 at ordinary income tax rates, because that is the amount that exceeds $1 million. (It is unclear based on the details provided in the proposals whether the $1,000,000 threshold will vary based on a taxpayer’s filing status.)

NOTE: The capital gains tax rate for households with income over $1 million would be increased from 20% to 39.6%, which, including the 3.8% Medicare tax, would also be 43.4%.

Limit Step-up Basis at Death

The Internal Revenue Code (under Section 1014) states that heirs acquire a decedent’s assets with a “stepped-up” basis equal to fair market value on the date of death. This presently allows beneficiaries to sell inherited assets without a gain due to appreciation at the time of the passing of the decedent. (Appreciation after the date of death would be taxable gain.)

The American Families Plan proposes to end “stepped-up basis” for gains in excess of $1 million ($2 million per couple). This proposal may result in a deemed sale of assets upon the passing of an owner.

The American Families Plan also proposes that, for family-owned businesses and farms given to heirs who continue to run the business, tax on the appreciation would be due only upon a sale or when the business is no longer family-owned and operated.

No tax on appreciation would apply for a gift to charity. Consequently, and as a result of the increased capital gains rates, gifts to charities would become much more attractive than under current law.

End Capital Gains Treatment for Carried Interests

Under current law, a partner who receives a share of future profits of (or a “carried interest in”) a partnership in exchange for services is not subject to income tax and may be allocated capital gains from the partnership or realize capital gains upon a sale of the carried interest. Generally, certain holders of carried interests are entitled to long-term capital gains treatment only if they satisfy a three-year holding period (rather than the normal one-year period). The American Families Plan proposes to modify this treatment so that hedge fund partners will become subject to ordinary income rates.

Changes to the capital gains rate might also eliminate the benefits of issuing stock as compensation, as capital gains would be taxable at the same rate as ordinary income.

End Section 1031 Like-Kind Exchanges

The American Families Plan proposes to end Section 1031 tax-free like-kind exchanges for real estate gains in excess of $500,000.

At this time, there is no determination on the dates these changes, if enacted, will be in effect.

Your Marcum Tax Advisors will continue to keep you up to date on these proposals as they are considered by Congress.