It appears that the White House is planning to make the effective date for its proposed tax increase on long-term capital gains retroactive to April 2021. If this were to happen, it may not only seem unfair, but it is also bad tax policy.
President Biden’s American Families Plan proposes increasing the tax rate on long-term capital gains for taxpayers with Adjusted Gross Incomes (AGI) greater than $1 million. Long-term capital gains for such taxpayers would be taxed at the same rate as ordinary income. The tax rate for these taxpayers would increase from 20% to 39.6%, plus the 3.8% Affordable Care Act tax on investment income. If this proposal is enacted, the Federal income tax could be as high as 43.4% on long-term capital gain income.
When the tax rates on long-term capital gains were increased in the past, the potential increase was announced along with a future effective date. A prospective effective date does two things: it avoids uncertainty for taxpayers and raises more tax dollars (at least in the short run). There have been two major increases in the tax rate applicable to long-term capital gains in the past 50 years. In the Tax Reform Act of 1986 (enacted October 22, 1986), the tax rate on long-term capital gains was increased from 20% in 1986 to 28% in 1987. This resulted in a 60% increase in the capital gains tax collected in 1986. The 1987 capital gains tax collections were slightly below 1985. The maximum rate on long-term capital gains was again increased in 2013 from 15% in 2012 to 23.8% in 2013. The expectation of this increase resulted in a 40% increase in the amount of tax collected on capital gains from 2011 to 2012.
The timing of payment of tax on capital gains is generally controlled by the taxpayer. If the tax rate seems too high, the taxpayer usually can wait to sell at a time when the tax rates are more favorable. Much research has been done on the optimal rate of capital gains tax to maximize the tax revenue. The higher the rate, the less likely taxpayers will sell assets and be subject to the tax. The American Families Plan’s proposed tax rate of 43.4% on capital gains is the highest tax rate on long-term capital gains in the past 100 years and the largest increase in the long-term capital gains rate in U.S. history. Many taxpayers who will be subject to this tax increase are likely to postpone recognition of capital gains longer than they would in the absence of a tax increase. If the American Families Plan effective date is retroactive, there will clearly be less tax collected than if the effective date were prospective (such as 1/1/22). Some in the Biden administration consider it a loophole to allow taxpayers to be able to sell prior to the effective date. Those who hold this view would seem to be more interested in soaking the rich than in maximizing tax revenue.
Tax Planning For Higher Capital Gains Rates
Since the proposal applies only to those taxpayers whose AGI exceeds $1 million, taxpayers may be able to plan their gains so that their income does not exceed that threshold. For sales of businesses or real estate, one might be able to keep AGI below $1 million by using the installment sale provision to spread the gain over two or more years. Installment sale treatment is not allowed for publicly traded stock. One possibility to avoid the higher capital gain rate on the sale of publicly traded stock might be to contribute the stock to a charitable remainder trust (CRT). The CRT could sell the stock and pay the donor an income stream for a period of years or for life (or joint lives). Depending on the individual taxpayer’s facts and the assumptions used, even taxpayers with little charitable motivation can end up better off than they would through a sale of the stock that is taxed 43.4% plus state income tax (if any).