What you need to know about Biden's capital gains tax plan

President Joe Biden’s American Families Plan includes some significant overall tax increases to fund its costs. A key part of his tax plan includes substantial increases in the capital gains tax rate for some taxpayers. Here is a rundown of what could change as far as capital gains and what this could mean for your clients. 

Capital gains tax basics 

Capital gains taxes are assessed on assets that are sold at a profit. While this is often associated with stocks, it can also apply to the sale of real estate, a business and other types of assets. Capital gains taxes are applied only to realized gains from the sale of the assets. 

Gains are the price received for the asset less your cost basis. Your cost basis includes not only the value of the asset when acquired, but also any costs to acquire the asset, such as commissions to purchase shares of a stock. 

There are preferential tax rates for long-term capital gains taxes. These are realized gains for assets held for at least one year. The current long-term capital gains tax rates are 15%, 20% or 23.8% for higher income taxpayers. Assets other than stocks may have different rates for capital gains taxes. 

Short-term capital gains on stocks are taxed at the taxpayer’s ordinary income tax rate, which is often higher than the preferential long-term rate. 

History of the capital gains tax 

Since the early 1950s, the long-term capital gains rate has been lower than the top ordinary income tax rate. 

In 1997, the top rate was reduced from 28% to 20%. In 2003, this was further reduced to 15%. under the Jobs and Growth Tax Relief Reconciliation Act.

The top rate increased to its current 20% in 2013. The Affordable Care Act added an extra 3.8% for the Net Investment Income Tax (NIIT) for taxpayers over certain income thresholds that became effective in 2013. 

What changes will Biden make to the capital gains tax? 

The Biden tax plan would raise the top marginal income tax rate to 39.6% from the current 37% level. For taxpayers with income above $1 million, the long-term capital gains rate would increase to 39.6% as well. When the NIIT is added in, this rate jumps to 43.4%. 

At this time, it appears that the Biden tax plan will leave the current capital gains tax rates for those at lower income levels as is. 

Another major change related to capital gains taxes proposed under the Biden tax plan is the elimination of the step-up in basis for inherited assets such as stocks, real estate and some other types of assets.

But that proposal is already hitting opposition from Democrats in Congress, who are said to be considering allowing beneficiaries to defer the tax bill as long as they hold the assets.

How will Biden’s capital gains tax affect the wealthy? 

The increased capital gains rate would reduce the amount of gains that a wealthy investor would be able to keep from selling an asset. Under the current rules, a $100,000 long-term capital gain would face a $23,800 tax bill at the federal level. With the proposed rates under the Biden tax plan, the taxes on this gain would jump to $43,400 for those above the income threshold. For a wealthy investor realizing gains on several holdings during a year, the increase in capital gains taxes could be significant. 

Passage of the Biden tax plan is not a certainty, and even if it does pass, some sections may be altered. That said, there are some planning considerations for the wealthy if it does pass. 

For wealthy clients who are charitably inclined, an increase of this magnitude in the capital gains tax might be a good reason to donate some of their appreciated shares to charity. This offers the benefit of a charitable deduction for the market value of the donated shares. It also removes any taxation of capital gains. This can be a very efficient way to make charitable donations under the current rules and likely under any revised rules.  

How will Biden’s capital gains tax changes affect ordinary Americans? 

On the surface, many non-millionaires might be saying to themselves, “Who cares? This doesn’t affect me.” 

However, ordinary Americans may still find themselves affected in a number of ways. First, if these rules are enacted, some experts say it could trigger a selloff in the stock market. While this would likely be short-term in nature, the portfolios of most investors could take a hit, including 401(k) plans and other investments. 

Owners of small to midsize businesses could also be affected. The impact could be twofold. 

First, small-business owners who sell their business for a price that pushes their income for the year over the $1 million threshold could see any capital gains on the sale of the business taxed at the new, higher rates.

Second, if a business owner dies and wants to pass the business on to their heirs, the value of the transaction could exceed the threshold where the heirs would be eligible for a step-up in basis on the value of the business. Based on an Ernst & Young study, this could have a negative impact on the heirs, the business and the economy as a whole, depending upon which version of the repeal of the step-up in basis is enacted.   

Another area where the proposed capital gains tax changes could affect ordinary Americans is when selling a home. For sellers of a primary residence, there is an exemption before any gains on the sale are taxed — $250,000 for an individual or $500,000 for a married couple. The rules state that the seller must have lived in the home for at least two of the five years prior to the sale to qualify for this exemption, though there are some exceptions to this rule. 

With home values skyrocketing in some markets, a home sale could bump some sellers over the $1 million income threshold for the year, even with the exemptions. This is especially true if the seller originally purchased the home during a down market, such as during the financial crisis of 2007-’08, when home values in many areas plummeted. 

What do Republicans think of Biden’s capital gains tax plan? 

As you might suspect, most Republicans don’t support these increases. It’s likely that the capital gains package “as-is” will be a tough sell to the GOP members of the House and of the Senate, where the Democratic majority is quite small.

Sen. John Thune, R-S.D., feels the entire Biden tax package will be a hard sell to both Republicans and to some Democrats. “I think they realize that you really run the risk of stepping on a lot of economic growth,” he told The Wall Street Journal. 

Not all Democrats are on board, either. “I think that there needs to be some differential, but the differential between ordinary income and capital gains is much too great, so I’m open to narrowing that,” Sen. Mark Warner, D-Va., said. Other Democrats have voiced concerns as well. 

This portion of the Biden tax package is sure to generate a lot of discussion on both sides of the aisle over the next few months. 

Capital gains: Ending the step-up in basis at death 

The Biden plan recommends a $1 million exemption before the elimination of the step-up in basis would take effect. 

The current step-up in basis for inherited assets can eliminate or at least reduce the capital gains taxes paid by heirs of an estate when they sell an inherited asset.

For example, if someone inherits 1,000 shares of stock worth $100,000 from a relative, the step-up in basis would establish this amount as the heir’s cost basis. Eliminating the step-up in basis would mean that the deceased’s cost basis would carry over to the inherited shares. For assets where the deceased had a low cost basis, this could mean very substantial capital gains for the heirs to deal with. 

For example, if these 1,000 shares had an original cost basis of $25,000, this could leave their heirs with $75,000 of inherited capital gains. These gains would be subject to taxes if the shares were sold, reducing the net amount of the inheritance. 

As mentioned above, ending or limiting the step-up in basis can complicate business succession plans that involve leaving a business to heirs. The higher taxes that the heirs would incur could limit the future growth of the business or in extreme situations could cause the business to shut down. 

Helping clients avoid capital gains taxes 

There are a number of ways that advisors can help their clients avoid a capital gains tax hit. These strategies are not new, but many will likely become more prominent should the Biden proposal pass. A few examples include: 

• Focus on asset location. Where possible, hold assets that will be subject to significant capital gains in retirement accounts. This could mean holding growth stocks in traditional or Roth IRAs, as well as in a 401(k) or other employer-sponsored retirement plans. This could also include self-directed retirement accounts for alternative assets such as real estate, cryptocurrency and a host of others.
• Sell appreciated assets before the new capital gains tax rates go into effect if this strategy would be beneficial in light of your client’s overall situation.
• Consider converting assets to a Roth account. This can make a great deal of sense due to the current low overall income tax rates and may prove to be a good way to avoid some of the potential capital gains tax hit your clients could face if these new rules are enacted. It can also be beneficial from an estate planning perspective.
• Wealthy clients should review their estate plans in light of the potential changes to the step-up in basis rules to look at ways their heirs could avoid some or all of a potential tax hit on inherited assets. They may want to reconfigure some things in light of this potential change.
• Consider donating appreciated assets to charity. Donating appreciated stock offers not only a charitable tax deduction based on the market value of the shares, but also avoids the payment of any capital gains taxes. Beyond a direct donation of assets, a donor-advised fund might be an alternative for clients to consider.
• Use tax-loss harvesting to offset any potential capital gains when rebalancing client portfolios. 

While nobody can accurately predict what the final capital gains piece of the tax and spending package will look like, we think it’s fair to say there will be a lot of negotiation on the final version of any changes to the capital gains tax rate.