| May 11, 2021

How to tax capital gains is a topic of much discussion today. Yet, we find that many people do not understand how we tax gains on assets. Generally, we tax long-term gains (assets held more than a year) at preferred rates. Assets sold less than a year after purchase are taxed as ordinary income. Realized losses (in other words securities or other assets sold for less than the purchase price) can be used to offset realized gains dollar-for-dollar. Realized losses can only be used against ordinary income at the rate of $3,000.00/year and carried forward until used against gains or until the loss is exhausted against income. A realized gain (in very general terms) is the difference between the purchase price and the sale price of an asset. For investment real estate, depreciation is recaptured and taxed upon sale. There are multiple additional complications involved that are beyond the scope of this discussion. Always seek competent advice before making any decisions. When we give our assets away, we also give away our basis and those to whom we transfer our appreciated assets will pay tax on the gain should they sell. This is not true when we give appreciated assets to a recognized charity. When we die, however, our heirs receive a step-up in basis. In other words, our heirs receive a new cost for tax purposes, which may be our date-of-death or an alternative date. Inherited assets are taxed when sold at the preferential long-term rate regardless of the holding period.

We tax capital gains at preferred rates for a number of reasons. First, we wish to encourage investment so as to stimulate jobs and the economy. Secondly, we realize that a portion of long-term gains are the phantom result of inflation, and thus not actually gains at all. The official policy of the Fed is now to achieve an average annual inflation rate of 2%.* Another way of looking at it is that the Fed wishes to devalue the dollar by an average of 2% annually. If a person bought an investment property for $500,000 today, he or she would need to sell their property for $609,497.21 after ten years in order to break even after inflation. After 20 years, that number rises to $742,973.70. Should inflation increase by 3% per year, the 20-year break even number rises to $903,055.62. With double-digit inflation during the 1970s and 1980s, it is easy to understand why changing how we tax gains became a bipartisan issue.

Housing perfectly illustrates how we promote investment while protecting homeowners from inflationary policies. Currently, individuals are entitled to a $250,000 exemption on a primary residence in which they have lived for two of the last five years. For couples, the number is $500,000. Without this exemption, inflation makes moving difficult, since the impact of inflation causes taxes on the old house to reduce the funds available to buy a new house. Upon death, this exemption is lost, but the step-up in basis makes the exemption unnecessary for our heirs.

Today, doing away with the step-up in basis upon death is being discussed. We do not yet know the details of what is being proposed, although some type of exemption for the first $1 million is expected.  We do know that a non-partisan desire to replace death taxes for those who have less than $11.7 million has existed for some time, since people with assets less than that no longer pay federal estate taxes. The SECURE Act, which forces heirs to take taxable distributions more rapidly from retirement plans, is one step already taken to recover lost death taxes on the medium wealthy. Doing away with the step-up in basis would be another way to tax this group. Should the rate increase to the 43% currently being discussed, taxes upon gains after death would be higher than current estate-tax rates.  For those in high-tax states, the tax could be well over 50%. This seems politically unlikely. Heirs to a family business worth $5 million could owe as much as $1,752,000 in federal tax alone. Current proposals would allow them to pay the debt, with interest, over 15 years. Few businesses of that size could bear a debt of that magnitude without failing. Many would sell to larger companies rather than forcing fire-sales on their children or bequeathing a crushing debt. Many employees would lose their jobs, many children would become employees of companies they used to own. Big business would love this, since they could suppress competition and increase business in one stroke.

Many of the reports that we read point out that the number of people impacted annually is under 3% of the population. This is because every small business does not sell itself every year. Likewise, business owners do not die every year, come back to life and die again. According to the U.S. Small Business Administration Office of Advocacy, there were 30.7 million small businesses in the United States that employed 59.9 million people, or 47.3% of the workforce.** The only way to know how many people are impacted is to know how many of these businesses are valued at more than $1 million above basis. Then we need to know how many people they employ. The employees most at risk of losing their jobs are those who work for the most successful companies, those that add the greatest number of new jobs and provide the best benefits. The need to sell or merge before the death or disability of the owners would be even greater than we saw with the old estate tax.

We do not know if current proposals will become law. Whatever happens, we will do our best to develop strategies to minimize the impact on our clients. Solid long-term planning will be essential.

*FRED Graph, Economic Research Division. Accessed 05/07/2021.