Before getting into what Biden is including in his tax plan for capital gains, we should first define what is a capital gain.
A capital gain is a sale of any property. This is different than selling inventory.
As an example, if you are in the business of selling bicycles and you buy one bicycle for $100 from the manufacturer and sell it for $150 to a customer, your gross profit is $50. This is ordinary income and taxed at ordinary income rates. Read as: higher taxes.
A capital gain is made when you sell property (capital asset) but you are not in the business of selling that type of property. If you bought 100 shares of stock for investment purposes at $10/share ($1,000 total cost) and then sold that stock later for $15/share ($1,500 total sale), you have a $500 capital gain.
Whether that capital gain is long-term or short-term depends on whether you hold the asset for a year. Under one year is short term capital gains. Over a year is long term capital gains.
With the current tax code, short term capital gains are taxed at whatever the taxpayer's ordinary income tax rate is. So if the taxpayer is in the 22% bracket, short-term capital gains will be taxed at 22% as well. Slight gotcha: your capital gains do get included in your adjusted gross income (AGI) for figuring out what bracket you are in.
If your $500 gain in this example was made over a year, it becomes long term capital gains. And long term gains (LTCG) have preferred tax rates. In other words, Congress has decided to reward this type of behavior by taxing it less than ordinary income types. LTCG tax rates are 0%, 15%, or 20% depending on your total income and filing status.
Here's a table of how the capital gains tax brackets work depending on your income and status:
Biden's plan has proposed a number of changes to the tax code. One of them is changing the capital gains rate in two important ways.
First, a long term capital gains tax hike for high earners who make at least $1 million a year. A lot of people have misinterpreted this to mean that only people with very high incomes will see this tax hike. But that's not really accurate. The vast majority of people who see these incomes over $1 million are doing so not every year, but in one specific year: the year they sell their business. This tax reform would change the capital gains tax rate to be equal to the taxpayer's ordinary income tax rate (which he also plans to raise to 39.6%).
So notice how this is effectively a doubling of the federal income tax on large capital gains from 20% to 39.6%. Also, there is the Net Investment Income Tax of 3.8% which is under current tax law, and will continue to be assessed under the Biden plan. So the total tax on large capital gains will go from 23.8% to 43.4%. Remember, this is just for federal tax. State income taxes may be more, depending on where you live.
The second way that Biden's tax proposal is planning to create a tax increase on capital gains is by eliminating the so-called step-up in basis.
The step up in basis occurs when people inherit property. This is most often in the form of a house being passed down to children upon the death of a parent.
Under the current tax code, the inheritor of that property gets a tax basis at the fair market value on the date of inheritance. In English, that means that if you inherit a house worth $250,000 then for tax purposes you "paid" $250,000. So if you turn around and sell it for $260,000 you have a capital gain of $10,000. And you'll owe taxes (if any) on that amount and how long you held it as a capital asset.
With Biden's plan, the step-up upon inheritance is eliminated entirely. So if grandma paid $5,000 for that house in 1957, you inherit it at a value of $250,000, and then you sell it for $260,000, you have a capital gain of $255,000.
That's obviously an enormous tax increase because of the increase of taxable income.
Imagine that this person is married, making $60,000 at their job, and has 2 kids. Under the old rules, they'd pay $0 in capital gains. Under Biden's proposed rules, they'd pay $51,000 in capital gains tax. Some might say, "Nice problem to have," but this is not some high earner or wealthy person. This is middle-class generational wealth transfer. On top of that, it will end up increasing their tax bracket on their ordinary income, increasing their individual income tax rate.
If the details were such that the taxable income were over $1 million for the year, then the capital gains tax on that $255,000 gain jumps up to $110,670.
In this article, I have only discussed one element of Biden's tax plan. There are many more elements to his proposal, almost all of which mean higher taxes. The two potential elements that would mean tax cuts are the un-capping of state and local tax deductions in your itemized deductions and changes to the child tax credit. Everything else in the tax plan, like payroll tax (social security tax) changes, corporate tax changes, and more all tax hikes.
I'm writing this in November of 2020 and it looks like Biden will indeed be the President in 2021. Whether he gets a Republican Senate or not is still unclear. So the political landscape of whether he will get his tax plan passed, and in what form, are still open questions.
The one thing that is clear though is that Biden's tax plan has targeted capital gains in a significant way. And it's a simple mechanism: tax something more and you get less of it. That means fewer business created, less investment, and less economic prosperity.
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