Increasing The Capital Gains Rate: Tax Planning In A Time Of Flux

Anticipating President Biden’s proposed increase in the capital gains tax rate, taxpayers are deciding whether and how to accelerate gains or how to defer them after an increase for as long as possible.

The uncertainty around the timing and extent of the increase, as well as other important details that will need to be established during the legislative process, makes short-term decisions a challenge for taxpayers who might meet the threshold for the proposed higher rate.

But if the rate goes up, deferral strategies will become more valuable in accordance with the size of the increase.

On April 28 Biden released the American Families Plan, which included a proposal to increase the capital gains rate for households with income exceeding $1 million to the 39.6% rate for ordinary income. The plan also proposed eliminating the step-up in basis at death for gains exceeding $1 million, or $2.5 million per couple when combined with existing real estate exemptions.

The announcement of the plan formally kicked off the legislative discussions and prompted taxpayers to consider what options they might have now and in the future.

The capital gains tax rate increase to an effective rate of 43.4% (the proposed 39.6% rate plus 3.8% net investment income tax) would put a lot more pressure on recognition events, said Steven M. Rosenthal of the Urban-Brookings Tax Policy Center.

Even for taxpayers who may eventually be subject to the higher rate, it might be premature to sell investments now. “The surefire way of dealing with a capital gains increase is to sell and realize the gains now before the rate goes up, but what if the rate doesn’t go up?” said Ian Weinstock of Kostelanetz & Fink LLP.

For U.S. taxpayers, that could be an expensive proposition. For taxpayers who aren’t U.S. residents, selling and repurchasing is a much easier choice, because they are subject to capital gains tax only on real estate investments.

Taxpayers may have time on their side in figuring out when to respond to a potential rate increase. It might be a matter of waiting to see how the legislation takes shape in Congress. “My hope is that as the process evolves, we’ll have more of an insight into the direction it’s going,” Weinstock said.

The release of the American Families Plan proposal was a step forward, but there’s likely still plenty of time before the resulting legislation becomes law.

Impact on Opportunity Zones

Steven Hadjilogiou of McDermott Will & Emery said some taxpayers are considering how to accelerate capital gains before a potential rate increase, but that under the Opportunity Zone regime, that’s hard to do.

He said it’s possible to accelerate deferred gain while retaining the 10-year holding period benefit, although not all acceleration methods work.

Hadjilogiou said qualified opportunity fund investments will still be valuable even if the rate increase becomes law, but that the deferral piece will become a cost.

“I think investors in the short term are going to look at that potential rate hike and say no to investing in a QOF because of that,” he added.

Congress and the Biden administration could modify the Opportunity Zone rules to allow the applicable tax rate to be the one that applied in the year the capital gain was realized, rather than the one that applies when the gain is recognized on December 31, 2026. 

Section 1400Z-2 doesn’t specify what rate applies, but Treasury clarified in regulations that the rate is the one in effect in the year the gain is recognized. 

Hadjilogiou noted that this is consistent with other deferral regimes such as the installment sale rules and even the rules for 401(k) plans, which apply the rate in effect in the year of the gain recognition.

Closely Held Businesses

Business owners who may not typically end up above the income threshold each year could face an unpalatably large tax bill when they decide to sell their business, or upon death. 

Thomas J. Nichols of Meissner Tierney Fisher & Nichols SC said gain realization could be draconian for closely held businesses. For example, for some of those businesses, the only point at which the owner-operator would reach the proposed $1 million threshold would be when they sell the business they’ve spent years building.

Spreading out the gain from the sale of a business over multiple years under the installment sale rules to avoid exceeding the threshold in any one year might be an option for some closely held business owners, but it might not be ideal.

The point of a sale for owners is often to cash out completely and not have to worry about keeping the business going.

“The decision whether or not to sell a business has so many implications, you can’t let tax completely drive the bus,” Nichols said. But the difference between a 20% rate for a taxpayer who materially participates in their business and a potential 43.4% rate is significant. “If that’s your nest egg, it’s really huge,” Nichols said.

The death of the owner of a closely held business is typically a difficult time of transition for the business, and adding to the tax burden at that juncture could compound the problems it already faces, Nichols said.

“The loss of that person who held everything together never fails to have a substantial impact in terms of continuity for the business,” he said.

Allowing the increased tax to be paid over multiple years might blunt the immediate impact but could still present a major challenge, because a closely held business may not return to the same level of profitability after the death of the principal owner, Nichols added.

Taxpayers with closely held businesses will likely explore options like donations to charity or transfers to children during life to avoid triggering some of the gains if the capital gains tax rate increases as proposed.

“These are highly personal decisions and dependent on a lot of factors that have nothing to do with tax,” Nichols said. “The combined income and estate tax burden could be as high as 60% under these proposals, and that could be devastating for a family business passing down to the next generation.”

Avoiding the Threshold

There’s no definition of income in the American Families Plan, but that will change if the proposal becomes law. Wherever the definition lands, it’s likely that taxpayers whose incomes are just above the threshold will attempt to drop just below it.

In a post on the Urban-Brookings Tax Policy Center’s blog, Robert McClelland explained that in 2018, around 40% of high-income households reported between $1 million and $1.5 million. By spreading income out over time when possible, taxpayers might avoid the income threshold.

That might not always be an option, but it could become a more important planning tool in the event of a large rate increase.

Other Options

Before a potential capital gains tax rate increase, taxpayers may decide to trigger gains they plan to realize soon anyhow so that they’re taxed at the current rate, rather than at the potentially higher rate later. 

Hadjilogiou said that not only QOF investors, but also those using installment sales have options for accelerating their gains.

Like-kind exchanges were whittled back to only real estate in the Tax Cuts and Jobs Act, limiting that route as an option to avoid recognizing gains. Rosenthal said taxpayers may start looking for investments that don’t throw off current income, such as growth stocks that don’t pay dividends.

Risk management techniques, other than selling the appreciated property, might become more attractive in an environment with higher capital gains tax rates, he said.

The constructive sale rules under section 1259 apply to relatively few categories right now, but as taxpayers look to put options, variable prepaid forward contracts, and other planning tools to defer gain, Congress might consider tightening those rules, he said. That could be a delicate balance, because under the current rules, taxpayers should pay tax if a derivative mimics the opposite of the position they hold, but rules that go far beyond that might discourage legitimate hedging.

The extent of the proposed rate increase could also prompt taxpayers to rebalance their portfolios before the higher rates take effect.

“Normally the tax incentives are so small, taxpayers wouldn’t bother, but it could be worth some attention here because the increase is so big,” Rosenthal said.

Exchange-traded funds may become more attractive to investors seeking to avoid the capital gains tax because those funds often use in-kind redemptions for some shareholders to avoid making dividend distributions for all shareholders, Rosenthal said.

Section 852 allows the funds to avoid recognizing gain upon the distribution of appreciated assets in kind as a redemption of shares. As the tax rate increases, the timing benefit of that rule becomes more attractive because it provides a way to defer tax.

What’s Next?

The American Families Plan is only the opening bid in what will invariably be a longer process of implementing a capital gains tax rate increase.

As that process unfolds, the effects on tax planning will come into focus.