Capital gains refer to the growth in the value of investments. For example, if you buy a stock at $10 per share, and you sell when the stock price rises to $20 per share, you will have a capital gain (of 100%, to boot!).
If an asset is sold for less than you bought it for, that would result in a capital loss. This article will touch on capital gains insofar as the taxes they incur, and specifically the changes proposed in President Joe Biden’s American Families Plan.
Capital gains and taxes
Capital gains taxes, or CGT, are incurred when investments are sold at a gain, as detailed above. Once assets are sold, the capital gains are considered to be “realized.” This is the necessary prerequisite for taxes to come into play, as the tax does not apply to unsold, i.e. “unrealized” capital gains.
So no matter how long you hold a stock, it will not incur CGT until they are sold. Once the gains are realized, however, the CGT is incurred, and the rate of this tax is higher if it has been less than one year.
If it has been more than one year, the gains are known as “long-term capital gains.” If it has been less than one year, the gains are known as “short-term capital gains.”
Whereas long-term capital gains have a fixed tax rate of 0%, 15%, or 20%, depending on your tax bracket, short-term capital gains are taxed like ordinary income.
It is thus important for investors to be aware of the difference between long-term and short-term capital gains tax, especially if engaging in “day trading,” which results (in theory) in lots of short-term gains as opposed to long-term gains.
Offsetting taxable capital gains for the year are any capital losses incurred. Capital losses, as noted, occur when an investment is sold for less than it was purchased for. The difference between these two—capital gains and losses—results in the “net capital gain,” which serves as the basis for one’s given CGT.
Capital Gains – Capital Losses = Net Capital Gain
It should also be noted, although this article won’t go into detail about it, that there are certain special CGT and exceptions, such as collectibles, owner-occupied real estate, and investment real estate.
Proposed capital gains tax increases
President Joe Biden’s American Families Plan plans to include a significant increase in the top federal tax rate on long-term capital gains, from the present 23.8 percent (20% plus a 3.8% net investment income credit on high earners) to 39.6 percent for the highest earners.
In addition, certain states would cause rates to be even higher, after local and state CGT is factored in. Importantly, the new CGT would only apply to Americans with incomes of $1 million or greater.
While the CGT tax increase could be passed retroactive to the beginning of 2021, a look at history shows that it’s not all that likely.
For example, President Trump’s tax cuts (the Tax Cuts and Jobs Act) didn’t take effect until the 2018 tax year, his first full year in office.
So, while Democratic control of both the House and the Senate make the passing of Biden’s CGT plan much more likely, it probably would not go into effect until 2022 at the earliest.
It also is no guarantee, given that Republicans will surely oppose it, and may also be joined by some Democrats, such as moderates like Krysten Sinema and Joe Manchin.
Reactions to the CGT increase
There have been numerous strong reactions to Biden’s American Families Plan and its CGT hike, particularly in the financial world, as one might expect.
Criticism of the proposal
Since Biden’s plan was announced, a lot of criticism has been levied against it. Some fear that it will hurt many of America’s biggest companies, who have also provided some of the most value to American investors through the appreciation of their stock prices.
Michael R. Strain, in an opinion piece for the Boston Herald, argues that Biden should look elsewhere to pay for new spending because the tax will hurt businesses and this will trickle down to workers, making them less valuable and suppressing wages.
Many critics join Strain in expressing concern about the tax hike’s effect on businesses and thus jobs.
Sen. Tim Scott of South Carolina described the proposed CGT increase as “the biggest job-killing tax hikes in a generation,” and a survey of CEOs by Business Roundtable showed a strong belief that Biden’s tax increases would make them less competitive, limit spending in research and development, and impede hiring.
Is the criticism overblown?
While the criticism raises some reasonable concerns, the reality is that for many Americans, not a whole lot will change. Robert McClelland, a senior fellow at the Tax Policy Center, calculates that only about 3% of households had unrealized capital gains of $1 million or more in 2019.
And, across the board, the stock market has not shown a substantial change in investment behavior, which is an argument shared by Alan Patricof on CNBC. In his view, “new companies will be started…funds will be formed. Private equity will prosper.”
According to Patricof, it doesn’t make sense that the rate increase, contrary to some arguments, would collapse the market. “Entrepreneurs are not going to stop and say, ‘Gee whiz, the capital gains rate is going up. I better not start my company,’” he added.
And many Americans, for example, those who bought stock in 401(k) plans, individual retirement accounts, and some other type of accounts, will not have their capital gains subject to the tax. Plus, as mentioned, the tax rate increase applies only to millionaires, which are not the majority of Americans.
Ultimately, according to a research note from UBS, around three out of every four U.S. stock investors would not be subject to an increase in the CGT rate.
It appears that Biden wants to arrive at more parity with taxes, as there is a stunning amount that goes uncollected each year through tax loopholes and havens.
According to CBS News, there’s an estimated 36% of unpaid federal income taxes owed by the top 1% of U.S. earners. If collected, this would result in some $175 billion added annually to federal revenues.
How might the CGT increase affect you?
Since most Americans are not in the 1%, however, let’s consider how the CGT increase might affect us more “average Joes.”
Mutual funds
One common example of how capital gains work differently than usual is with mutual funds.
As many Americans have mutual funds, either personally or through retirement plans, it’s important to be aware that mutual funds pay out distributions that are subject to CGT, even if reinvested.
And since these distributions occur throughout the year, they are usually considered short-term capital gains. Once again, though, the CGT increase proposed in Biden’s plan will only apply to those with more than $1 million in annual income.
Real estate
Another area that could potentially affect the middle class is the real estate market. As financial planner Sharif Muhammad shared with CNBC, “The proposed increase in federal as well as state capital gains tax rates could sting [home sellers] on the margins.”
Many sellers, however, can avoid paying CGT on profits from selling their home due to a special tax break, in which single taxpayers can subtract up to $250,000 from their profits, while married filers may be able to exclude up to $500,000. Beyond this, the profits must be subject to CGT.
And while many will be able to save on CGT, home sales in higher-dollar markets could potentially push some sellers over the $1 million threshold set in the Biden plan.
In expensive markets such as Los Angeles, San Francisco, or New York, the median list price for a home is well over $1 million.
To give an example, if someone earns $150,000 per year—and they make a $1.5 million profit on their home—they will still have annual income above the $1 million threshold, even after factoring in the $250,000 exclusion.
Retirement
It’s important to consider your retirement plan and what you believe your future tax rate will be. If you think you will eventually exceed the $1 million threshold, then Biden’s proposed CGT increase would end up affecting you at that time.
What should you do?
If you are planning on selling your home, make sure to do some proactive tax planning. Consult a tax advisor or financial planner knowledgeable with real estate to protect yourself from the increased burden of a higher CGT rate.
Also, don’t forget to take into account any renovations that you have made to the home. These can reduce your overall profits by adding on to the home’s original purchase price, or “cost basis.”
You should also be sure to give yourself plenty of time so you are well prepared for the tax environment and market in which you are selling.
If you are preparing for retirement, you might also consider converting your traditional IRA to a Roth IRA, because money in Roth accounts grows tax-free and distributions are also tax-free. Plus, if you convert now, you lock in the current tax rate.
Finally, for those higher earners who meet the $1 million+ income threshold, you might consider locking in your capital gains at the 20% rate now and then repurchasing the shares. This will give you a new cost basis for future sales, which will likely lessen the amount of capital gains.
Looking ahead
Ultimately, it’s no guarantee that Biden’s American Families Plan is passed, and the proposed CGT increase takes effect.
Nonetheless, it’s important to prepare for the possibility and understand the implications so you can best manage your finances. For most Americans, however, there should not be too much concern.
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