Capital Gains Tax Rate Increase Could Be on the Horizon

High-income investors may want to take action to realize gains at current, lower tax rates. President Biden’s current tax plan will raise the top tax rate on capital gains from 23.8% to 43.4% for households with income over $1 million. However, the President’s proposed budget appears to reflect this tax increase occurring in late April of 2021. If Congress agrees to a retroactive tax increase, tax planning will not be possible.

The administration has generally been trying to avoid imposing retroactive tax increases, and many of its proposals would take effect in 2022. Capital gains are different, because the rate increase is so significant, and because taxpayers have so much control over when they report income. Retroactive tax increases have occurred before and courts generally give Congress leeway to exercise its taxing powers. The rationale for retroactivity is that there is a long history of taxpayers accelerating capital gains before tax increases take effect.

There is some question of whether a retroactive, mid-year tax increase could pass both the House and Senate.  Retroactive tax increases are highly unpopular, and would require significant changes to tax reporting forms.  Additionally, the political reality is that assuming unanimous Republican opposition, all Democratic Senators would have to vote for this change in order for it to become law.

Biden’s plan also changes the tax rules for unrealized capital gains held until death. The capital gain tax rate increase and the changes to the treatment of gains at death are tied together.

Currently, people who die with unrealized gains do not pay any income taxes. Their heirs pay only when they sell assets and only on any gains since the prior owner’s death. That gives people an incentive to hold on to appreciated assets and, without the proposed change to the tax rules at death, the higher tax rate would prompt more people to hold assets until death.

The Biden proposal would apply income taxes to those unrealized gains at death. It would have a $1 million per-person exemption, plus existing exclusions for gains on principal residences. Family-owned farms and businesses would get special rules that would defer their taxes as long as they own and operate the businesses.

Taxing capital gains at death is different from the estate tax, which is based on net worth and currently has an exemption of $11.7 million per person. The administration has currently not proposed any changes to the estate tax.

However, although not contained in current budget proposals, President Biden during his campaign proposed reducing the estate tax exemption amount from $11.58 million for 2020 to $3.5 million and increasing the top rate from 40% to 45%.  An act containing these provisions has been introduced in the Senate.

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