Financial planning and investment advice or tips
In anticipation of President Biden’s proposed increase in the capital gains tax rate, taxpayers will decide whether and how to accelerate profits or defer them for as long as possible after an increase.
The uncertainty about the timing and extent of the increase, as well as other important details that need to be determined in the legislative process, make short-term decisions challenging for taxpayers who might reach the threshold for the proposed higher rate.
However, as the rate increases, postponement strategies become more valuable as the rate increases.
On April 28, Biden released the American Families Plan, which included a proposal to increase the capital gains ratio for households with incomes above $ 1 million to 39.6% for normal income. The plan also envisaged removing the death base top-up for profits greater than $ 1 million, or $ 2.5 million per couple, when combined with existing real estate exemptions.
The announcement of the plan officially kicked off legislative discussions and prompted taxpayers to consider what options they might have now and in the future.
Increasing the capital gains tax rate to an effective rate of 43.4% (the proposed rate of 39.6% plus 3.8% net capital gains tax) would put a lot more pressure on recognition events, said Steven M. Rosenthal of Urban-Brookings Tax Policy Center.
Even for taxpayers, who may be subject to the higher tax rate, it may be premature to sell investments now. “The surefire way to deal with a capital gain is to sell and realize the profits now before the interest rate goes up, but what if the interest rate doesn’t go up?” Said Ian Weinstock of Kostelanetz & Fink LLP.
This could be expensive for US taxpayers. For non-US taxpayers, selling and buying back is a much easier choice as they are only subject to capital gains tax on real estate investments.
Taxpayers may have time on their side to figure out when to respond to a potential tax hike. It might be a matter of waiting to see how legislation takes shape in Congress. “My hope is that as the process progresses, we will have a better understanding of the direction it is going,” said Weinstock.
The publication of the proposal for the American Families Plan was a step forward, but there is likely to be a long time before the resulting legislation comes into effect.
Impact on opportunity zones
Steven Hadjilogiou of McDermott Will & Emery said that some taxpayers are considering how to accelerate capital gains before a possible rate hike, but that it is difficult to do under the opportunity zone regime.
He said it was possible to accelerate deferred profit while maintaining the benefit of the 10-year holding period, although not all acceleration methods work.
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Hadjilogiou said qualified opportunity fund investments will still be valuable even if the rate hike is mandated by law but the delay comes at a cost.
“I think investors will be looking at this potential rate hike in the short term and will say no to investing in a QOF for that reason,” he added.
Congress and the Biden Administration could change the rules for the Opportunity Zone to allow the applicable tax rate to be that applied in the year the capital gain was realized, rather than if the gain was realized on December 31st Will be recorded in 2026.
Section 1400Z-2 does not specify which rate applies, but the Treasury Department has clarified in the regulations that the rate applies in the year in which profit is recognized.
Hadjilogiou found this to be compatible with other postponement rules such as the installment rules and even the rules for 401 (k) plans, which apply the rate in force in the year of profit realization.
Entrepreneurs who don’t typically end up above the income line every year could face an uncomfortably high tax burden if they decide to sell their business or if they die.
Thomas J. Nichols of Meissner Tierney Fisher & Nichols SC said that realizing profits for closely held businesses could be draconian. For some of these companies, for example, the only point where the owner / operator would hit the proposed $ 1 million threshold would be to sell the company they’ve built for years.
Splitting the profit from selling a business over several years according to the installment selling rules to avoid exceeding the threshold in one year may be an option for some close-knit business owners, but may not be ideal.
Often times, the selling point for homeowners is paying off completely and not having to worry about keeping the business going.
“The decision whether or not to sell a company has so many implications that you can’t let the bus take full control of the bus,” said Nichols. But the difference between a rate of 20% for a taxpayer who has a material stake in his business and a potential rate of 43.4% is considerable. “If that’s your nest egg, it’s really huge,” said Nichols.
The death of the owner of a closely run business is usually a difficult transition period for the company, and an increase in the tax burden by that time could compound the problems it already faces, Nichols said.
“Losing that person who held it all together always has a significant impact on the continuity of the company,” he said.
Paying the increased tax over several years could mitigate the immediate impact, but it could still be a major challenge as a closely-run company may not return to the same level of profitability after the death of the major owner, added Nichols.
Taxpayers with closely run businesses are likely to consider options like charitable donations or lifetime transfers to avoid triggering any portion of the profits when the capital gains tax rate is increased as proposed.
“These are very personal choices and depend on many non-tax-related factors,” said Nichols. “The combined income and inheritance tax burden under these proposals could be as high as 60%, and that could be devastating for a family business that is passed on to the next generation.”
Avoid the threshold
There is no definition of income in the American Families Plan, but that will change when the proposal becomes law. Wherever the definition lands, it is likely that taxpayers whose incomes are just above the threshold will try to go just below it.
In a post on the Urban-Brookings Tax Policy Center blog, Robert McClelland stated that about 40% of high-income households reported between $ 1 million and $ 1.5 million in 2018. By spreading income over time, if possible, taxpayers could bypass the income limit.
This may not always be an option, but it could become a more important planning tool in the event of a sharp rise in tariffs.
Prior to a possible hike in the capital gains tax rate, taxpayers can decide to trigger profits they want to realize soon anyway so that they will be taxed at the current rate rather than the potentially higher rate later.
Hadjilogiou said that not only QOF investors but also those who take advantage of installment sales have options to accelerate their profits.
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The same type of exchange was reduced to real estate only in the Tax Cuts and Jobs Act, which restricted this avenue as an option to avoid the recognition of profits. Rosenthal said taxpayers could start looking for investments that don’t turn in current income, such as growth stocks that don’t pay dividends.
Risk management techniques, aside from selling the valued property, could become more attractive in an environment with higher capital gains tax rates, he said.
Section 1259’s constructive selling rules currently apply to relatively few categories, but as taxpayers seek put options, variable prepaid futures and other planning tools to defer profits, Congress might consider tightening those rules, he said. This could be a delicate balance because under current regulations, taxpayers should pay taxes if a derivative is imitating the opposite of their position, but regulations going well beyond that could prevent legitimate hedging.
The magnitude of the proposed tax hike could also lead taxpayers to realign their portfolios before the higher tax rates take effect.
“Usually the tax incentives are so small that taxpayers wouldn’t care, but it might be worth paying attention here because the increase is so big,” said Rosenthal.
Exchange traded funds could become more appealing to investors looking to avoid capital gains tax, as those funds often use in-kind redemptions for some shareholders in order to avoid dividend payouts for all shareholders, Rosenthal said.
Section 852 permits the Funds to avoid recording gains on distributions of valued property values as redeeming Shares. As the tax rate increases, the time benefit of this rule becomes more attractive as it provides a way to defer taxes.
The American Families Plan is just the opening offer in an invariably lengthy process to implement a capital gains tax increase.
In the further course of this process, the effects on tax planning will come into focus.