What Tax Changes Could Mean for Income Tax on Capital Gains

US Capitol building
The Biden Administration recently released its budget for the fiscal year 2022, and the document contains many significant potential changes to the country’s tax laws. This article will focus on Biden’s proposed changes to the income tax on capital gain.

The headline on capital gain reform is, of course, the rate. For taxpayers making over $1 million, Biden wants to tax capital gains at ordinary income rates, which for these high-earning taxpayers would also be increased to 39.6% under Biden’s proposal. In cases in which the “net investment income tax” would concurrently apply to a taxpayer’s capital gains, these proposals would push the total top rate paid on such gains to 43.4%.

The budget states that this change in rates would apply to “gain required to be recognized after the date of the announcement.” As reported by the Wall Street Journal, this vague statement apparently reflects an intent to apply the increased rate to gain recognized after the Biden Administration’s announcement of the American Families Plan on April 28, 2021, and thus this change could be retroactive to that date.

Aside from the increased rate, however, Biden also seeks to alter which events require a taxpayer to recognize gain. Although Biden’s proposal would not apply these new rules retroactively, the proposed changes to the scope of these so called “recognition events” could have a dramatic impact on basic tax planning.

Generally Applied Rules Under Current Law:

  • A taxpayer can generally make a gift of an appreciated asset, including at death, without recognizing the gain associated with that appreciation.
  • A transfer of property into, or a distribution of property from, trusts, partnerships, or other non-corporate entities can often be achieved without gain recognition.
  • Although limited to real property by the Tax Cuts and Jobs Act of 2017, taxpayers have long been allowed to exchange certain like-kind property without recognizing gain.

If enacted in its entirety, Biden’s proposal would, to a certain degree, require taxpayers to recognize gain with respect to each of these types of transactions. More specifically:

  • Biden’s proposal would generally require a taxpayer making a gift of appreciated property to recognize gain on that appreciation on the date of the gift and require a decedent to recognize gain on any appreciation in assets transferred at death.
  • A transfer of property into, or a distribution of property from, trusts, partnerships, or other non-corporate entities would become recognition events. On its face, this proposal is very broad, and it is not entirely clear whether it is intended to apply only to transactions that are also gifts or whether it would apply to basic business transactions such as standard contributions to, and distributions from, partnerships.
  • The proposal would also largely eliminate the non-recognition treatment currently granted to certain like-kind exchanges involving real property.

Indeed, the proposal would, in certain cases, even treat as a recognition event the mere holding of property. In this regard, Biden proposes to tax the gain on unrealized appreciation in property held by a trust, partnership, or other non-corporate entity if that property has not been subject to gain recognition within the prior 90 years. The 90-year period would run from January 1, 1940, meaning that the first possible gain recognition under this odd rule would apply as of December 31, 2030.

Biden’s proposal does contain a series of exclusions or exceptions from the expanded scope of recognition events, summarized below.

Exclusions & Exceptions:

  • Generally, the proposal would grant each person a $1 million exclusion from the recognition of capital gain on the transfer of property by gift or at death.
  • A decedent’s transfer of property to a spouse and outright transfer of property to a charity would not be considered recognition events. It is not entirely clear from the proposal whether a similar exclusion would apply to gifts made during a taxpayer’s lifetime.
  • Biden would extend the current gain exclusion rules related to the sale of a principal residence to “all residences,” and he would retain the current gain exclusion rules for the sale of certain small business stock.
  • Transfers of tangible personal property other than collectibles would not be considered recognition events (e.g., taxpayers could transfer household furnishings without recognizing gain).
  • With respect to like-kind exchanges of real property, if a taxpayer otherwise qualified under the current deferral rules for such exchanges, Biden would continue to allow an annual per taxpayer deferral of $500,000 of gain on such exchanges.

If enacted in its entirety, Biden’s tax reform proposal would upend the general framework for taxing capital gain. Although the headline is the change in the capital gain tax rate applicable to certain high-earning taxpayers, the rules outlined above related to the timing of recognition events would also mark a significant change to this framework. Moreover, unlike the tax-rate proposal, Biden does not propose to retroactively apply these revised recognition event rules. As a result, taxpayers will need to monitor these proposals to determine what actions they might consider taking ahead of the effective dates of these rules should they become law.

Be sure to consult with your tax advisor with questions or contact Kernutt Stokes.