During this first business week of 2021, the ebullience that many felt as 2020 came to an end is being replaced by the dull throb of awareness—the awareness that Covid-19 continues to trend upward in terms of infection rates, transmissibility, and deaths; the awareness that our nation is still divided politically; and, for those of us who pay taxes, the awareness that the tax changes proposed by President Biden and Vice President Harris will now likely become reality.
President Biden has proposed numerous tax increases for both the middle and upper classes. Ultimately, marginal tax rates will be rejiggered by Congress in coordination with the White House. The same, of course, is true for capital gains treatment. However, for higher earners and small businesses, most would agree that long term capital gains rates are likely to increase substantially under a Biden-Harris Administration.
Biden’s tax plan asks “those making more than $1 million to pay the same rate on investment income as they do on their wages.” The capital gains tax is a fee that the government imposes on profits made from the sale of assets like real estate, stock, the sale of businesses, collectibles, and other assets with increased value—the “gain.” A capital gain occurs where the asset’s total sale price is greater than the asset’s original cost. By contrast, a capital loss occurs when the total sale price is less than the original cost.
Capital gains taxes become due when you sell your investment. For example, if you own a rental property that has increased significantly in value over the years of your ownership, you will not owe a capital gains tax during those years of ownership. However, once you sell the property, you must report the profit on your tax return and pay a tax at your income bracket’s capital gains rate. As you will note, capital gains taxes are often a form of double taxation in that you will have paid taxes annually on all income derived from the asset (assuming it is an income-producing asset) and you will be taxed again (at the federal and, most likely, also at the state level) when you sell the asset.
Currently, an individual earning between $0 and $40,000 pays a 0% long-term capital gains tax. An individual earning between $40,000 and $441,450 pays a 15% long-term capital gains tax, and an individual earning more than $441,450 pays a 20% long-term capital gains tax. Earned income for each of these brackets includes the sale proceeds of the asset. And added to each of these tax rates is the 3.8% Affordable Care tax surcharge (known to many as the “Obamacare Tax”).
As a candidate, Biden claimed that, for individuals and small businesses earning less than $1 million, capital gains tax rates would not be affected under his presidency. However, Biden proposed to increase the 20% capital gains tax rate from 20% (plus the 3.8% surcharge) to a whopping 37% (plus the surcharge) for a total federal capital gains tax rate of 40.8%. Add to that the state level capital gains tax rates (also expected to go up) which, in 2020, ranged from 13.3% in California to 2.9% in North Dakota (with nine states having a 0% rate); and you are looking at capital gains tax rates of 54.1% in California (assuming no increase in 2021 which is unlikely), 51.55% in New Jersey, 49.62% in New York state (plus a 10% surcharge in New York City for a whopping 59.62% in NYC) and 45.8% in Massachusetts.
As noted above, this was the calculus under the more conservative proposal by President-Elect Biden when he was a presidential candidate and believed he would have to work through a Republican-controlled Senate. Since the election is over, and it is now certain that we will have a Biden-Harris Administration in place, albeit with razor thin margins in both the House and Senate, it is anyone’s guess what the actual rates will be. But the word on the Hill is that the hike in capital gains taxes will likely apply to taxpayers who make less than the $1 million that candidate Biden proposed and that the increases could be even higher at the federal level than the proposed 17% hike for those earning $1 million (this 17% hike represents an 85% rate increase). A similar calculus is being considered by most state legislatures with capital gains regimes given the economic conditions illustrated by the various states’ balance sheets.
Regardless of how this all plays out; all is not lost. There are numerous strategies that are perfectly legal under the tax code, many of which have been in place for a century or more. Section 1031 is a great example. Under Section 1031, when very specific guidelines as to timing, identification, use of a qualified intermediary and other logistical and administrative mandates are followed, a taxpayer can defer the payment of capital gains on investment real estate by “replacing” both debt and equity in a new real estate investment or portfolio of same. If the taxpayer is tired of being a landlord but desires the use of Section 1031, he or she may invest in a Delaware Statutory Trust investment that offers all the benefits of a 1031 exchange but as a passive investment with a professional management team in place.
The true magic of Section 1031, applicable to exchanges of actively managed properties and investment in Delaware Statutory Trusts, is the step-up in basis at death. When a real estate investor defers the payment of capital gains and, perhaps, does so multiple times over the course of his lifetime, his heirs will receive a step-up in basis at the time of the death of the investor. In the example of a $1.5 million investment that is sold for $3 million years later via 1031 exchange and the replacement property is sold again for $8.5 million via 1031 and is held as such at the time of the investor’s death, an initial investment of $1.5 million has led to a windfall of $8.5 million for the investors heirs (a $7 million return on the initial $1.5 million investment) without ANY capital gains taxes ever being paid by either the investor (because of prudent 1031 exchanges) or the heirs (because of the step-up in basis feature of Section 1031). However, the step-up in basis could be in real trouble. Biden campaigned on eliminating the step-up in basis, but the proposal was not taken seriously because it was widely believed that Republicans would maintain control of the United States Senate. It is now a certainty that the Democrats will take control of the Senate and, therefore, the step-up is now in jeopardy. Thus, other strategies designed to reduce and/or defer capital gains tax liability deserve serious consideration.
During the Trump Administration, Congress and the IRS gave taxpayers the opportunity to invest in qualified opportunity zones (QOZ) via qualified opportunity funds (QOF). QOF investments are designed to invest in real estate and businesses in QOZs. QOZs are areas designated as economically distressed. The tax incentives for these types of investments included deferring and potentially reducing taxes on capital gains. This framework was created as part of the 2017 Tax Cuts and Jobs Act to encourage investment in underfunded, low income, and distressed communities. Once designated a QOF, the fund must invest at least 90% of its assets in QOZs to receive preferential tax treatment and it must make substantial improvements to the property. Under Section 1400Z-2 of the Tax Cuts and Jobs Act of 2017, investors who elect to reinvest capital gains into Opportunity Funds will receive multiple capital gains tax benefits that will allow an investor to defer, reduce, and ultimately eliminate future capital gains.
- Section 121 (exclusion of gain from sale of principal residence)
For one’s primary residence Section 121 provides a $250,000 ($500,000 for a married couple) exclusion on capital gains such that long term capital gains taxes are only owed when appreciation is above that threshold.
- Section 453 (the installment sale provision)
Prior to the passage of the current tax code, one used to be able to sell collectibles and other highly appreciated assets such as works of art under Section 1031. All such appreciated assets, save for real estate investments, are no longer covered under Section 1031. For the sale of such assets, and also for the sale of businesses where goodwill and other intangibles and where any real estate is either not a part of the sale or is de minimis in comparison to the scope of the sale, we can structure transactions pursuant to Section 453, the installment sale provision, that can defer and delay the payment of capital gains taxes, putting the portion of the sale price that would otherwise have gone to the federal and state government to work for the taxpayer in a wide array of income producing investments.
- Sections 170(a), 170(c) and 501(c)(3) (Charitable Donations and Tax-Exempt Organizations—Charitable Remainder Trusts, Donor-Advised Funds and Family Foundations)
The tax code provides various incentives for charitable giving that can be extremely helpful in mitigating taxes (and capital gains tax liability in particular). These vehicles work differently but each provides for the elimination of capital gains tax on highly appreciated assets and up to a 30% deduction on present adjusted gross income.
- Charitable Remainder Trusts (CRTs)
Charitable remainder trusts allow the taxpayer to convert a highly appreciated asset such as real estate or stock into lifetime income. CRTs reduce present taxes and estate taxes imposed in the future. No capital gains taxes are paid upon the sale of the asset and CRTs allow for donation to the charity or charities of one’s choice. The asset is moved into an irrevocable trust prior to sale, and an immediate charitable income tax deduction becomes available. The trustee then sells the asset at full market value and reinvests the full, non-taxed proceeds into income-producing investments. For the remainder of the life of the taxpayer, the trust pays out income. And, at the time of the death of the taxpayer, the remaining trust assets are donated to charity.
- Donor-Advised Funds (DAFs)
A donor-advised fund is similar to a charitable investment account and exists for the sole purpose of funding philanthropic organizations that the taxpayer supports. When a taxpayer contributes cash, securities or other assets to a DAF at a public charity (e.g., Fidelity Charitable, Vanguard Charitable) the taxpayer is generally eligible for an immediate tax deduction. Then the donated funds can grow on a tax-free basis and the taxpayer/donor can recommend grants to basically any charity (qualified as such by the IRS) of the donor’s / taxpayer’s choice. With highly appreciated assets, proper use of a DAF will wipe out 100% of all long-term capital gains tax liability and will create a present deduction of up to 30% of the taxpayer’s adjusted gross income.
- Family Foundations
For total control of how and where charitable giving will take place, those with windfall capital gains (or simply massive capital accumulation) often create foundations. From a capital gains tax standpoint, if a taxpayer were to contribute appreciated property to a foundation, he / she would be entitled to receive an income tax deduction for the full, fair market value of the property contributed. When the foundation sells the property, it will pay no capital gains taxes on the sale. Moreover, the taxpayer will receive a present tax deduction on the amount contributed of up to 30%. These deductions are available in each successive tax year where there is charitable giving to the foundation. The IRS requires that 5% of average investments made by the foundation be distributed annually. Moreover, the expenses incurred in running the foundation must be reasonable. That said, the assets of the foundation will continue to grow on a tax-free basis, creating a legacy that should last well beyond the life of the taxpayer/donor.
- Section 1202 (the Small Business Stocks Gains Exclusion)
Section 1202, also known as the Small Business Stocks Gains Exclusion, allows capital gains from select small business stock to be excluded from federal taxation. Section 1202 only applies to qualified small business stock that was acquired after Sept. 27, 2010, and which has been held for at least five years. Section 1202, part of the PATH Act of 2015, provides an incentive for non-corporate taxpayers to invest in small businesses. A qualified small business stock held for more than five years prior to sale will have a portion or all of its realized gains excluded from federal taxation. These gains are also exempt from the 3.8% Affordable Care tax surcharge. To qualify, the small business must meet several highly specific criteria.
- Section 179, the JOBS Act and the CARES Act (election to expense certain depreciable business assets)
Qualified improvement property (QIP) is defined as an improvement to an interior portion of a non-residential building. QIP does NOT include the enlargement of the building, the installation of elevators or escalators or changes to the building’s internals structural framework. Under the current law, real estate owners can now claim 100% first year bonus depreciation or elect an accelerated 15-year depreciation schedule for QIP placed in service between 2018 and 2022. While not technically a capital gains solution, this provision has a very short lifespan but can be highly lucrative in terms of tax minimization for real estate owners with qualifying property.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Michael Burwick plays three professional roles. He is a partner in the business, tax, and entertainment, sports and media practice groups at the national law firm, Taylor English Duma LLP. He is the General Counsel at Asset Strategy Holdings and its RIA subsidiary, Asset Strategy Advisors, LLC, an SEC-registered investment advisor that manages (in conjunction with its sister company) more than $11.5 billion on behalf of high-net-worth and ultra-high-net-worth individuals, families, businesses, charities, and institutions. And he is the President of Capital Gains Tax Strategies LLC, a tax consulting firm that works with both Asset Strategy Advisors and Taylor English in creating custom solutions for individuals, families, businesses and other entities with capital gains tax issues or concerns.