Introduction

What is a Capital Gain?

Capital gains are defined as the profit earned on the sale of an asset that has increased in value. Both individuals and businesses can accrue capital gains when they sell an asset. This article will focus on how capital gains taxes are assessed in the United States, proposed changes to how capital gains are treated, and common strategies for deferring capital gains.

Capital Gains Tax 2021

The American Taxpayer Relief act in 2012 increased the maximum long-term capital gains rate to 20%. The Affordable Care Act in 2013 added a 3.8% net investment income tax on certain types of income, including dividends and capital gains, bringing the maximum rate to 23.8% for those with $441,451 of annual income or more.

Factors Affecting Capital Gains

Here we review some important considerations relating to capital gains, who pays them, and how they are assessed.

Capital Gains are Disproportionately Paid by High-Income Households

According to the Tax Policy Center, fewer than one in seven individual taxpayers reported taxable gains in 2006. Eighty-three percent of capital gains were reported by households with income over $200,000 and 61% of capital gains were reported by taxpayers with income over $1 million. 

Because the majority of capital gains are paid by high-income households, increases in the capital gains tax are seen as an easy way to tax the wealthy. However, wealthy taxpayers are also better-equipped to defer or otherwise avoid capital gains tax through investment and tax strategy. 

For example, since gains are not taxed until they are realized, wealthier households can wait to sell assets until doing so is beneficial. Taxpayers can wait for favorable changes in the tax law or wait until they have a large capital loss to offset the gains. Wage-earners usually cannot use these tactics; they owe tax in the year that they receive income.

Capital Gains are Usually not Recurring Income

A taxpayer could be considered high-income in a single year when they sell an asset such as a family business or an invention. This complicates the idea of using a capital gains hike as a vehicle to tax the ultra-wealthy. According to the Small Business Investor Alliance, “[w]hen a small business is sold, it is often over the $1 million dollar threshold for being ‘rich’, and therefore taxed at a higher rate.”

Inflation Erodes the Real Value of a Capital Gain

Capital gains are not indexed for inflation. For example, if an asset was purchased at $100,000 in 2010 and sold in 2020 for $180,000, the taxable gain would be $80,000. At the top rate of 23.8%, the taxes owed would be $19,040. Adjusting for inflation, the real value of the sales price is $151,655 in 2010 dollars, and the real value of the tax levied is about $16,000. The effective tax rate in this case would be over 30%.

Inflation considerations are especially relevant considering the 5% year-over-year jump in the Consumer Price Index—a common inflation benchmark—in May.

Double Taxation

On an individual level, most dividends and capital gains have already been subject to corporate income tax. Therefore, the same earnings are taxed once at the corporate level, then again at the individual level. 

The Tax Foundation contends that double taxation creates a bias towards immediate consumption over savings. The issue of double taxation is sometimes used to justify the lower capital gains and corporate tax rates relative to the regular income tax rates.

Capital Mobility and Competitiveness

Capital is easily shifted between countries, and investors will tend to move capital to countries with lower capital gains rates. The average top state and federal capital gains tax rate in the United States is 28.6 percent, the 6th-highest rate of the 38-member Organization for Economic Cooperation and Development. The rates being considered under the American Families Plan would leave businesses in every state with the highest capital gains rate in the OECD. The increase could lead to a combined average tax rate of 48 percent.

Proposed Changes to Capital Gains Tax

Increase in Capital Gains Rate

Under the changes proposed by the American Families Plan, capital gains could be taxed at the same rate as ordinary income. The proposed top marginal tax rate of 39.6%, combined with the 3.8% NIIT would result in a top capital gains tax rate of 43.4%.

Limits on the Step-Up in Basis

Under the current law, heirs to an appreciated asset do not owe capital gains on any increase in the asset’s value. For example, a building that appreciated from $1 million to $3 million during the life of the owner would have its basis stepped-up to $3 million upon death of the owner. The heirs do not owe any capital gains tax on the $2 million “step-up” in basis. 

The Penn Wharton Budget Model estimates that raising the rate to 39.6% would actually decrease revenue by $33 billion over fiscal years 2022-2031 because high-income taxpayers are likely to avoid realizing capital gains when rates are high. However, the same model predicts that an increase in the rate, combined with limitations on the stepped-up basis would raise $113 billion over the same period. Thus, applying limits to the stepped-up basis is a key source of funding for the proposed law.

The law would allow a $1 million exemption for single taxpayers and $2.5 million for married couples. In the example above, a single heir to the $3 million property would only owe taxes on $1 million of the $2 million step-up in basis, while a married heir would not owe any capital gains tax due to the $2.5 million exemption.

Limits on 1031 Exchanges

The proposed law would also limit the amount of capital gains eligible for deferral through 1031 exchanges. The amount of deferred gains would be capped at $500,000 for single taxpayers under the proposed limits. Section 1031 exchanges are discussed in further detail below.

Common Capital Gains Deferral Strategies

Taxpayers may use a wide array of tools to defer capital gains including 1031 exchanges, opportunity zones, installment sales, and charitable trusts. 

Deferring Capital Gains with a 1031 Exchange

A 1031 exchange is a tax-deferred exchange that allows the gains from one property to be used to purchase another “like-kind” property. Capital gains from the initial sale are not taxed (“unrealized”) until the sale of the target property. The definition of “like-kind” is permissive, with the IRS stating that “real properties are generally of a like kind, regardless of whether they’re improved or unimproved.” A piece of raw land could, for example, be exchanged for a hotel, restaurant, or other existing building.

The target property must be identified within 45 days of sale and acquired within 180 days. A “reverse” exchange allows for a replacement property to be acquired before the sale of the original property through an intermediary. The taxpayer must then sell the original property within 180 days.

The IRS states that a third party should be used to ensure that the both transactions are “mutually dependent parts of an integrated transaction.” If an intermediary is not used, the taxpayer risks not qualifying for deferral of capital gains tax.

In general, recapture tax can be deferred with a 1031 exchange, with the exception that the exchange of improved land for raw land will result in recapture for depreciation claimed on the improvements.

There is no limit to how many times or how frequently 1031 exchanges can be used. Any deferred gains will disappear when the owner dies and the basis is stepped-up. This means that by combining the 1031 exchange with the step-up in basis, capital gains are not only deferred but are ultimately forgiven.

Opportunity Zones and Qualified Opportunity Funds

Opportunity zones are distressed communities where new investments are eligible for preferential tax treatment. A qualified opportunity fund (QOF) is an investment vehicle that is organized for the purpose of investing in an opportunity zone.

By meeting certain requirements, taxpayers can defer taxes on capital gains, dividends, and other eligible gains by investing those gains into a QOF. Investment of the gains must take place within 180 days of selling the asset.

Taxes on invested gains are deferred until the property is sold or until December 31, 2026, whichever comes first. A 10% step-up in basis is applied after 5 years and a 15% step up in basis after 7 years. Since the deferrals for invested gains expire in 2026, only the 5-year, 10% reduction is available for new money invested in qualified opportunity funds in 2021.

After ten years, the cost basis of the property is equal to its fair market value at the time of sale, so investors will owe no capital gains tax on appreciation of the property. However, investors will still be taxed on their original gains on December 31, 2026, as stated above.

Selling a Capital Asset via an Installment Sale

An installment sale allows taxpayers to receive payments from a sale over multiple tax years. The total capital gain is split among the installment payments on a pro rata basis. This method can spread out a large capital gain over several years, resulting in a lower marginal tax rate.

Charitable Remainder Trusts

Often part of estate planning, charitable trusts, specifically charitable remainder trusts, allow taxpayers to donate appreciated assets to charity. The charity manages the asset and pays out a portion of the income generated by the property. Upon death or at the end of a defined period, the charity takes possession of the property.

The value of the gift is deductible over five years. Since the property belongs to the charity upon death of the investor, no estate taxes are due. If the charity sells the appreciated assets, the capital gain is untaxed.

A charitable trust may not be generally applicable or appropriate for most transactions. However, it can be a useful tool for estate and retirement planning.

Conclusion

Capital gains are an important part of the tax law with many moving parts. Increases, decreases, or other adjustments to how capital gains are treated have real effects on individual taxpayers and businesses in the United States.

At Lumpkin Agency, we are connected to a network of tax and business professionals with a wide array of experience. If you are interested in tax strategy or tax deferral on real estate, consider requesting a cost segregation estimate for your property. If cost segregation is not a good fit, we may be able to connect you to accounting and tax professionals capable of helping you to improve your tax strategy.

For more information please contact our Director of Cost Segregation at clayton@lumpkinagency.com.

The information provided in this blog is intended for general information only, and is not meant to constitute tax advice.