#greenbook

BFSG Presents “Great Client Questions”: Capital Gains

By:  Andrew Donahue, CFP®, MHA, |Wealth Manager|Financial Planner

As a firm we take pride in having some of the brightest clients around the U.S. (and beyond). In fact, we are often reaching out to you for insights within the various industries you work to check the pulse of the U.S. economy. Occasionally, during these conversations, our team is so taken by the caliber of question and observation we receive from clients that we want to share them with you as we receive them (including our team’s response).

This week’s “Great Client Question” comes from “Client X,” who recently noticed something interesting about President Biden’s proposal to increase taxes on long-term capital gains.

Client X Question:

I am expecting a large capital gain this year. I’ve heard the Biden administration just announced an April 2021 effective date for their new tax increase on capital gains. Is this true? I’d like to realize my gain at the existing (lower) tax rate before the new (higher) rate takes effect. Obviously, I won’t be able to do that if the new law will be effective as of two months ago, in April.

To respond to Client X, we asked one of our in-house congressional experts (former Hill staffer and BFSG wealth manager, Andrew Donahue, CFP®) to share his insight. Here is his response:

Situation

As a refresher, the long-term capital gains tax usually applies to a stock, a bond, or a real estate property (although there are other types of capital assets).

Here’s how the tax works:

  1. After you hold a capital asset for more than a year, if you sell it for a gain, the federal government will apply a “long-term capital gains tax” on the amount of the gain.
  1. The exact tax rate (%) will depend on your income in the year of gain.
  1. As it stands right now, the highest possible tax rate (20%) is reserved for “high earners” ($445,850+ for single filers, $501,600+ for married filing jointly or qualifying widow(er), $473,750+ for head of household, or $250,800+ for married filing separately). For everyone else, the tax rate is most likely 15% but for some “low earners” it might be 0%.

On April 28th, before a joint session of Congress, President Biden announced his desire to increase the top capital gains tax rate from 20.0% to 39.6% for the highest of high earners (households earning $1 million or more annually). Most insiders in Washington expect this tax increase to be signed into law this year. Where the speculation gets more interesting, however, is when the new law would take effect.

It’s an important question not only for households earning more than $1 million annually, but also for anyone who expects a unique or one-time capital gain this year that could push their income above $1 million. If so, depending on your tax professional’s advice, you may want to realize (quickly) long-term capital gains at the existing rate (15-20%) to avoid paying higher taxes at the Biden rate (39.6%).

This tax avoidance strategy is not possible, however, if the effective date of the pending law is April 2021, as Client X heard.

Background

Rumors of an April 2021 effective date are based primarily on a report released by the Treasury Department in May, referred to as the “green book.” Traditionally, green books are published by the Treasury Department in conjunction with the release of the president’s budget to help legislators and staff understand the impact of revenue proposals the president has proposed. If a president claims that he or she can generate revenue to pay for social programs, legislators usually want to know exactly how much revenue the president thinks he or she can raise to cover the expense.

Green books include effective dates for major revenue proposals simply because an assumption for a start-date is needed for Treasury to generate a formal revenue estimate. In the latest green book, which accompanied President Biden’s first budget, the Treasury Department included an assumption that the long-term capital gains tax increase would be retroactive to the “date of announcement” (presumably the joint session of Congress on April 28th).

Analysis

The effective date in the green book is not authoritative. Instead, April 28th is better understood as a starting point for negotiation in Congress. Pretty soon, legislators will shift to using other agencies, departments, and staff to score their own analyses of their own tax bills. These legislative drafts are what drive changes to law, not presidential budgets which are largely aspirational. Future congressional scores will explore other effective dates for the proposed tax increase.

Here is another way to think of it: These are complex policy issues and complex revenue calculations; sometimes in Congress it just helps to get everyone on the same page by starting with a shared assumption.

Furthermore, politically, an argument could be made that a retroactive change is unlikely to move the revenue needle enough for the Biden administration to justify further offending a well-heeled constituency (read: donors) with congressional elections around the corner and the House up for grabs. In other words, the juice from a retroactive effective date – which is a bit unusual from a tax policy perspective – may not be worth the squeeze.

Recommendation

Is an April effective date possible? Yes. These legislative proposals are dynamic, and they interact and clash with one another daily behind the scenes (for example, infrastructure talks could impact policy decisions on capital gains). If at any point the Biden administration and/or Democrats need to find revenue to secure their legislative plans, they may negotiate for the April effective date.

Ideologically, too, White House officials have been vocal about a desire to design a tax increase that prevents taxpayers from taking advantage of any gap before the increase begins. They cite a long history of taxpayers accelerating capital gains before tax increases take effect. For instance, according to the Tax Policy Center, capital gains realizations jumped 60% and 40% in 1986 and 2012, respectively, when similar capital gains tax increases last took effect.

As negotiations in Washington stand presently, however, we assess the likelihood of an April 2021 effective date as somewhere in the vicinity of less than likely. Rather, based on what we are observing, we might expect an effective date as early as the first committee action (such as late summer or fall when the tax-writing House Ways and Means Committee begins to mark up a bill) or perhaps as late as January 2022 (the start-date of other proposed tax changes).

We advise clients to approach long-term capital gains this year with a sense of urgency and conservatism. As always, we also recommend close consultation with your tax professional.

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