President Biden’s proposed American Families Plan would make significant changes including a capital gains tax rate increase, elimination step-up basis for inherited property, and limits to section 1031 like-kind exchanges. Here we discuss how the capital gains tax rate works and the proposed tax changes.
Capital Gains Tax: How Does It Work?
Capital gains tax is the tax you pay on the profit earned after the sale of a capital asset. A capital asset can include stocks, bonds, investment properties, a business, etc. There are two types of capital gains tax that need to be considered, short-term and long-term. Short-term capital gains tax applies to assets that have been held for less than one year. These gains are taxed as per the ordinary income tax rate (10%, 12%, 22%, 24%, 32%, 35% or 37%). In the case of long-term capital gains, you are taxed at rates of 0%, 15%, or 20%, depending on your income and filing status. This rate is typically lower than the ordinary income tax rate.
Of course, not every capital asset is sold at a profit. If the current value of the asset is lower than its original purchase price, then you can incur a loss too. Capital losses can be used to offset your capital gains. First capital losses are applied against capital gains of the same type. Then the net loss, either short term or long term, can be deducted against the other type of gain. For example, if you have a net short-term loss of $7,500 and a net long-term gain of $4,000 then your net capital loss is $3,500. Up to $3,000 of the net capital loss can be deducted from other types of ordinary income.
A capital gain or loss is calculated by using the “cost basis” or “tax basis” of an asset. Typically the basis is the value at which the asset was purchased. However, if the asset was inherited the adjusted basis is the market value of the asset at the time of the owner’s death. This readjustment is known as the step-up basis. It can be beneficial for tax purposes as it allows the heir to avoid or reduce capital gains tax as per the original purchase price of the asset.
To understand this better let’s consider an example, suppose that the owner of a capital asset originally purchased it for $200,000. When the asset is transferred to its heir, its value gets adjusted to $280,000 to match its current market value. If the heir then sold this asset at $300,000 then as per the readjustment, their capital gain would only be $20,000. This step-up basis allows the heir to significantly reduce their tax burden on the sale of the asset.
What Changes Does Biden’s Plan Propose to Make to Capital Gains Taxes?
President Biden’s tax plan proposes a number of changes to capital gains tax that could have a major impact.
Increase the Top Income Tax Rate
The new tax plan proposes a tax hike for the top income tax bracket, increasing it from 37% to 39.6%. As mentioned earlier, the IRS taxes short-term capital gains are taxed at the ordinary income tax rate. This means that high-income investors could have a tax rate of up to 39.6% on short-term capital gains. For 2021 the top tax bracket includes the following taxpayers:
- single filers with income over $523,600
- married filing jointly with income over $628,300
- head of household filers with income over $523,600
- married filing separately with income over $314,151
Increase in the Long-term Capital Gains Tax Rate
The plan also proposes changes to long-term capital gains tax rates, nearly doubling the tax rate for high-income individuals by increasing it from 20% to 39.6%. This tax increase applies to high-income individuals with an AGI of more than $1 million. These taxpayers would have to pay a tax rate of 39.6% on long-term capital gains. The IRS also charges high-income individuals an additional net investment income tax (NIIT) at a rate of 3.8%. This could increase the proposed tax rate to 43.4% on capital gain for individuals with an income exceeding $1 million.
Let’s take a look at the long-term capital gains tax rate for the tax year 2020:
|Filing Status||0% Rate||15% Rate||20% Rate|
|Single||up to $40,000||$40,001-$441-450||Over $441,450|
|Married filing jointly||Up to $80,000||$80,001 – $496,600||Over $496,600|
|Married Filing Separately||Up to $40,000||$40,001 – $248,300||Over $248,300|
|Head of Household||Up to $53,600||$53,601 – $469,050||Over $469,050|
The table below showcases the current long-term capital tax rates for the tax year 2021:
|Filing Status||0% Rate||15% Rate||20% Rate|
|Single||Up to $40,400||$40,401 – $445,850||Over $445,850|
|Married filing jointly||Up to $80,800||$80,801 – $501,600||Over $501,600|
|Married Filing Separately||Up to $40,400||$40,401 – $250,800||Over $250,800|
|Head of Household||Up to $54,100||$54,101 – $473,750||Over $473,750|
Elimination of the Step-up Basis
The Biden tax plan has also proposed eliminating the step-up basis that applies to inherited assets. As discussed earlier, the IRS readjusts the value of these assets to match the current market value, allowing heirs to avoid paying or reducing capital gains tax. Eliminating the step-up basis will require individuals to pay tax on the full profit earned on the sale of inherited assets. According to the Joint Committee on Taxation, enforcing this policy would increase tax revenue by $105 billion over a 10-year period.
Limitation of 1031 Exchange
The American Families Plan would limit a tax break used by real estate investors called section 1031 like-kind exchanges. Under section 1031 investors are able to avoid capital gains tax on proceeds of a property sale if the capital gains are re-invested in another property within 180 days. The proposed tax law changes would disallow the use of section 1031 for capital gains over $500,000.
President Biden’s plan has also proposed making the tax changes retroactive to April 2021. Although it is possible, changes will most likely become effective by January 2022.
How Will These Changes Impact the Average American?
It is important to note here that the tax plan does not propose any changes in the capital gains tax rate for individuals at a lower to middle-income level. The average American will benefit from a number of tax breaks included within the tax plan. These changes are targeting higher-income earners.
Small to medium-sized business owners may also be affected. If these business owners choose to sell their business at a price that increases their annual income to exceed $1 million, then they would have to pay higher taxes on the capital gains earned through this sale. Additionally when a business is passed to the business owner’s heirs. they may not be eligible for a step-up basis if it is sold. It is still unclear to what extent family businesses will be protected from these tax law changes.
The proposed changes could also impact Americans when they sell a home. Homeowners that sell a primary residence are exempted from capital gains taxes on the gains of a sale up to a certain amount. The exemption amounts are $250,000 for an individual and $500,000 for a married couple. However, home values have increased rapidly in certain markets. As a result, sellers could earn capital gains over $1 million and be subject to higher capital gains tax rates.
How Can High-Income Investors Control Their Capital Gains?
If enforced, the Biden tax plan could generate significant costs for high-income investors. However, proper tax planning can help you navigate these challenges. If you are worried about how the proposed tax plan could impact your earnings, here are some tips that can help you out:
Plan Your Asset Sales
One way to control your tax burden is to plan the sale of your assets carefully to determine how much tax you will owe for a specific tax year. You can sell your assets slowly to make sure that your long-term capital gains do not exceed the $1 million dollar threshold. Another option is installment sales to stretch capital gains over time and avoid spikes in income.
Review Your Estate Plan
If you are a high-income individual, we also recommend reviewing your estate plan to determine how your heirs can avoid some or all of the tax they might have to pay on inherited changes.
Donate to Charity
You can consider donating appreciated assets to charity. Doing so can help you qualify for a charitable tax deduction based on the market value of the assets and you can also avoid paying any capital gains taxes on the donation.
Harvest Tax Losses
Another way to minimize gains is by tax-loss harvesting. This strategy involves selling certain assets at a loss to offset capital gains and reduce your tax liability. The IRS also allows investors to claim up to $3000 capital losses against non-investment income. However, married couples who file separately can only claim up to $1,500. You can also carry any unused losses forward to offset your gains in other tax years.
Plan For Retirement
Hold appreciating assets in retirement accounts such as traditional IRA or self-directed IRA. Retirement account contributions are tax-deferred and grow tax-free, unlike other investment portfolios. When funds are withdrawn from the account ordinary income tax rates are applied.
Partner with a Trusted Tax Accountant at Eco-Tax
The American Families Plan can hold strong implications for high-income investors as well as ordinary Americans. While it can boost tax revenues significantly, it can also increase investment costs for wealthy individuals. Create a plan with a trusted advisor to navigate the potential impact of these changes on your investment portfolio.
We at Eco-Tax are ready and here to support you through it all. To learn more about how our tax planning services could help you, contact us today to book a free consultation with one of our trusted advisors. We look forward to partnering with you!