There has been lots of chatter lately about some proposals around changing how we tax capital gains, and especially around a proposal to tax unrealized capital gains. This is due to the Harris/Walz campaign saying they generally support the proposals that the Biden Administration included in their Fiscal Year 2025 Revenue Proposals.
To be clear, those proposals did not become law, they were just proposals.
Because I’m interested in financial topics like this (as well as the politics of it), I decided to dive a bit deeper into these proposals to see if I could understand them better. The following is my best current understanding of some of the various proposals. It’s certainly possible that I didn’t get everything right, and I undoubtedly am missing some of the nuances, but I think it’s a pretty good summary that will help all of us better understands the issues.
What Are Capital Gains?
It’s important to understand what a “capital gain” even is. When you purchase an asset for a certain price, that asset appreciates in value, and then you sell that asset at a higher amount, the difference between what you paid for it and what you sold it for is a capital gain (as opposed, for example, to income that you earn, which is considered “ordinary income”). Until you actually sell the asset, any gains are referred to as “unrealized capital gains” – you only incur the actual gain when you sell. For most people, the two assets they likely have that incur capital gains would be a house that they own and investments in stocks and bonds.
How Are They Currently Taxed?
Capital gains currently get preferential treatment when compared to ordinary income.
For example, if you file as married filing jointly and your taxable income (including any realized capital gains):
- is less than $94,050 (in 2024), then you pay no taxes (0%) on your capital gains (you would still pay taxes on your earned income based on your tax bracket).
- is between $94,050 and $583,750, then you would owe 15% tax on any of the capital gain that took you over the $94,050 amount (any under that amount would still not be taxed).
- is over $583,750, then you would owe 20% tax on any of the capital gain that took you over $583,750 (any between $94,050 and $583,750 would still be taxed at 15%; any below $94,050 would be taxed at 0%).
Note that these rates are much lower than the tax rates for earned income.
It’s also important to understand that there are some significant exceptions to this. Two of the most common ones are
- If you sell your primary residence you can exclude (meaning it’s not taxable) up to $500,000 in capital gains ($250,000 if single).
- If you hold on to these assets until you die, your heirs receive a “step-up in basis”, which means any unrealized capital gains are not taxed at all (0%). Your heirs inherit the assets and “start fresh”, treating the assets as being purchased at the price of their value when they were inherited, not at the cost they were actually purchased at.
What Are The Proposed Changes?
The Biden Administration’s Fiscal Year 2025 Proposals (which the Harris/Walz campaigns says they generally support) contained three provisions related to capital gains. Let’s look at each one of those separately.
Changing The Step-Up In Basis at Death Provision
This proposal would change the step-up in basis at death, but importantly has a $1 million exemption. So if you had assets (in your taxable brokerage account, this does not apply to tax advantaged accounts like 401ks, 403bs, 457bs, or IRAs) that had unrealized capital gains of over $1 million, then your estate/heirs would owe 20% capital gains on the amount over $1 million.
That’s only on the capital gain, not the total amount. So if the asset is worth $3 million but you original paid $1 million, the capital gain is $2 million. So your estate/heirs would owe 20% on $1 million in gains ($2 million in gains minus the $1 million exemption), or $200,000 in taxes, which is 6.67% of the entire $3 million amount.
Changing the Tax Rate on Capital Gains
This proposal would change the tax rate on some capital gains for certain people from the capital gains tax rates (0%, 15%, 20%) to ordinary income tax rate (currently the highest is 37%, although there are separate proposals to raise that to 39.6%). But this only applies to people who have over $1 million in taxable income (including realized capital gains) in that year, and the ordinary income tax rate of 37% only applies to the amount of capital gains over $1 million.
(Update 9-5-24: Harris/Walz released some additional details – as well as other proposals – yesterday. This included taxing the capital gains of those with over $1 million in taxable income at 28%, not at the highest ordinary income tax rate.)
So if your taxable income prior to capital gains was $900,000 and you had $200,000 in realized capital gains, the first $100,000 of those capital gains would be taxed at the current 20% and the second $100,000 (the amount that surpassed $1 million taxable income in total) would be taxed at
your ordinary marginal tax rate of 37%28%.
Taxing Unrealized Capital Gains
Currently capital gains are taxed only when you realize them (when you sell them). This proposal would change that to taxing some capital gains for certain people each year, even if they haven’t yet sold them and realized that capital gain. But this would only apply to people with a net worth of over $100 million (about 10,000 Americans), and it wouldn’t even apply to all of them.
- It applies only to people with at least $100 million in wealth who do not pay at least a 25% tax rate on their income (inclusive of unrealized capital gains).
- You’d also only pay taxes on unrealized capital gains if at least 80% of your wealth is in tradeable assets (i.e., not shares of private startups or real estate).
- There are also various exceptions/modifications for things like family owned businesses, small business stock, and a $5 million exclusion (so the first $5 million is exempt from taxes) for transfer of assets during life or at death.
It’s also important to realize that any taxes paid on unrealized capital gains will eventually offset the taxes owed when those gains are realized (so they aren’t taxed twice, they are just taxed sooner). It’s not completely clear (to me) exactly how capital losses will be handled, but it appears to say that they would be treated similarly to current law, where capital losses can be carried over and used to offset future gains.
Is This Good or Bad?
Well, everyone is going to have their own opinion about that :-).
Pros
The arguments in favor of these (as delineated in the proposals) are:
- Current laws “disproportionately benefit high-income taxpayers and provide many high-income taxpayers with a lower tax rate than many low- and middle-income taxpayers”
- “The rate disparity between taxes on capital gains and qualified dividends on the one hand, and taxes on labor income on the other, also encourages economically wasteful efforts to convert labor income into capital income as a tax avoidance strategy.”
- When a wealthy person’s wealth goes up by a large amount of money, it’s more like income even if it’s not a realized capital gain because they often borrow against those assets and use it as disposable income.
- It raises more revenue that can then be “spent” on other things that benefit more people.
Cons
Some of the arguments against that I have seen include:
- Philosophically, some people feel it’s unfair to have to pay taxes on gains that aren’t realized.
- Wealthy people shouldn’t be “penalized” for being wealthy.
- It’s socialism (redistribution of income).
- It could provide a disincentive for some people to invest.
What Do I Think? (if you care)
The above is factual (to the best of my knowledge). Below is my opinion, so feel free to skip.
Well, it’s complicated. I generally think these proposals are reasonable and directionally correct, but I don’t know enough about the details and there may be possible ramifications I haven’t considered. The arguments against that I’ve heard (listed above) don’t bother me.
- The realized vs. unrealized debate is somewhat semantic, this change just smooths out when taxes get paid.
- The wealthy people affected by this won’t be materially impacted by any of these changes.
- Philosophically I don’t have a problem with the wealthy paying more in taxes. (Briefly, our system provides outsized rewards to a small portion of society in a way that doesn’t fairly allocate where and how those rewards were actually generated.)
- I don’t believe it provides any disincentive at all. If you are wealthy and have the opportunity to make even more money, but you’ll pay a bit more taxes on that additional amount, you still come out way, way ahead. (Similar to the mistaken belief that some people have that they don’t want to increase their salary if it bumps them into the next tax bracket, not understanding the progressive nature of our tax brackets.)
Finally, it’s important to realize that these proposals as written have very little chance of becoming law. Democrats would have to not only win the White House, but also the House and Senate. And they would likely have to win the House and Senate by large margins as some Democrats would be opposed to some or all of these proposals. So even if they did win the trifecta, any legislation along these lines that would actually get passed into law would look very different and would likely be “watered down.”
But I still think it’s very useful to think about these proposals for (at least) two reasons.
- To truly understand what the proposals would do (as opposed to what certain people claim they will do).
- To think more deeply about how our tax system works and to ponder how we might change it for the better.
Sources
Fisch Financial 