The retroactive effective date for the capital gains tax increase is a bad idea

It appears that the White House plans to make the effective date of its proposed long-term capital gains tax increase retroactive to April 2021. If this were to happen, it may not only seem unfair, but it is also a bad one. fiscal policy.

President Biden’s American Families Plan proposes to increase the long-term capital gains tax rate for taxpayers with Adjusted Gross Income (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 Affordable Care Act tax of 3.8% on investment income. If this proposal is approved, federal income tax could go up to 43.4% on long-term capital gains income.

When 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 term). There have been two major increases in the tax rate applicable to long-term capital gains in the last 50 years. In the Tax Reform Act of 1986 (enacted on October 22, 1986), the tax rate on long-term capital gains was increased from 20% in 1986 to 28% in 1987. This resulted in an increase of 60% on capital gains tax collected. in 1986. The 1987 capital gains tax collection was slightly lower than in 1985. The maximum rate on long-term capital gains increased again in 2013 from 15% in 2012 to 23.8% in 2013. 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 capital gains tax is generally controlled by the taxpayer. If the tax rate seems too high, the taxpayer can generally wait to sell at a time when tax rates are more favorable. Much research has been done on the optimal capital gains tax rate to maximize tax revenue. The higher the rate, the less likely taxpayers are to 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. term in the history of the United States. Many taxpayers who will be subject to this tax increase are likely to postpone capital gains recognition longer than they would in the absence of a tax increase. If the effective date of the American Family Plan is retroactive, clearly less tax will be 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 sell before the effective date. Those who hold this view seem more interested in drenching the rich than in maximizing tax revenue.

Tax planning for higher rates of capital gains

Since the proposal applies only to those taxpayers whose adjusted gross income exceeds $ 1 million, taxpayers can plan their earnings so that their income does not exceed that threshold. For business or real estate sales, adjusted gross income could be kept below $ 1 million by using the installment sale provision to spread the profit over two or more years. The installment sale treatment is not allowed for publicly traded stocks. One possibility to avoid the higher rate of capital gain on the sale of publicly traded shares might be to contribute the shares to a remaining charitable trust (CRT). The CRT could sell the shares and pay the donor an income stream for a period of years or for life (or joint lives). Depending on the facts of the individual taxpayer and the assumptions used, even taxpayers with little charitable motivation may end up better than if they sold the stocks that are taxed at 43.4% plus state income tax (if applicable).

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