Washington Capital Gains Tax Shows Impact of State Tax Planning

The legal nuance that led Washington State Supreme Court to find its new capital gains tax to be constitutional involves the fact that it’s called an excise tax under state law. And while the US Supreme Court weighs taking the case, it’s a nuance that tax professionals should understand.

The capital gains tax applies to individuals at a rate of 7% on net gains exceeding $250,000. Tax-loss harvesting—incurring capital losses to offset gains—is limited to long-term capital losses. Short-term capital losses aren’t used to offset capital gains subject to Washington’s capital gains tax.

This underscores the various technical aspects of Washington’s state law. It also raises awareness that a state’s law may not conform to federal income tax provisions. Federal tax law allows the netting of differing classifications of capital gains and losses, so for federal purposes, a net capital gain is the net long-term capital gain less the net short-term capital loss.

The Washington capital gains tax provides an important lesson for tax professionals and their clients: It may be beneficial to understand the differentiating federal and state tax rules in a particular situation as well as assess additional federal tax rules to explore ancillary state tax rules for tax-lessening avenues.

A further look at the aspects of certain federal income tax rules might help guide state income tax planning considerations.

The Tax Cuts and Jobs Act of 2017 capped the annual deduction for property, sales, and income taxes for those who itemize deductions at $10,000 ($5,000 for a married individual filing a separate return). The limitation for these state and local taxes will expire at the end of 2025 unless legislation changes this provision.

Regardless of the TCJA, those who itemize deductions may need to evaluate whether they are subject to the alternative minimum tax, which includes, as part of its calculation, modifying or removing any SALT expense deducted for federal tax purposes.

Federal tax provisions that limit or reduce the benefit of deducting SALT expenses increase the cost of SALT payments. When a state implements a new tax or increases its existing SALT considerations, both the state tax increase and potential reduction of federal tax benefit make focusing on state tax planning more important.

Planning for Pass-Throughs

In certain activities owned through pass-through entities, such as partnerships or S corporations, a state’s law may impose mandatory state income tax payments at the entity level or permit elections so state income tax payments at the entity level can be attributed to the respective or distributive share of income to the owners of those entities.

What does this accomplish? In late 2020, the IRS issued Notice 2020-75 explaining that Congress provided that “taxes imposed at the entity level, such as a business tax imposed on pass-through entities, that are reflected in a partner’s or S corporation shareholder’s distributive or pro-rata share of income or loss on a Schedule K-1 (or similar form), will continue to reduce such partner’s or shareholder’s distributive or pro-rata share of income as under present law.”

More than 30 states have enacted pass-through entity tax provisions, often referred to as SALT workarounds. Importantly, they demonstrate how federal tax rules are generally applied and how state tax rules sometimes may invoke specialized planning or tax reduction strategy opportunities.

Washington state permits certain capital loss carryover computations under specific parameters. However, another state might not allow capital loss carryovers. For tax planning purposes, harvesting losses for state tax purposes may require precision.

For example, the Pennsylvania Department of Revenue explains that it has “no provisions for the carryover of losses from one tax year to another year.” Therefore, tax-loss harvesting exceeding realized capital gains may be lost and not allow for offset of future incurred capital gains.

Maryland doesn’t differentiate tax rates between ordinary income and capital gains income, but it conforms to the federal income tax treatment of net capital gains, so tax-loss harvesting has both federal and state income tax benefits.

Massachusetts taxes short-term capital gains at 8.5% and long-term capital gains at 5%. Massachusetts allows capital losses exceeding capital gains to offset interest and dividend income up to $2,000. Federal law permits up to $3,000 of capital losses to offset ordinary income.

While the concept of using capital losses against other types of income applies to both federal and Massachusetts instances, the amounts and type of income allowed to be offset aren’t the same.

Outlook

States may impose taxes on nonresidents on certain types of activities or assets within that state. Therefore, tax-reducing strategies and planning could be involved across multiple state jurisdictions.

State tax rules can differ significantly from federal tax laws, so the opportunity to reduce state income tax exposure needs careful analysis particular to each state. When federal law limits or caps the amount of state income tax payments that can be taken as an itemized deduction, individuals may benefit from more in-depth state income tax reduction planning.

The case is Quinn v. Washington, U.S., 23-171, response brief 11/3/23

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Tom Kelley is the national director of income tax planning at Wilmington Trust, where he provides analysis and insights on income tax planning, charitable planning, and estate planning to high-net-worth families and business owners.

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