In Case of Capital Gains Tax Hike, Don't Panic

With a new administration in place, many Americans are concerned about the prospect of higher taxes. Their anxiety is justified — with a record $3.1 trillion budget deficit and pandemic-related stimulus packages projected to lead to even higher federal debt, there is a strong probability of at least some tax increases ahead.

Plans to raise taxes are further fueled by the desire among some influential legislators to reduce income inequality through higher taxes for upper-income taxpayers.

In his election campaign, President Joe Biden put forth an extensive list of planned tax increases. It is unlikely, however, that all these measures will be enacted as proposed, especially in the first year of the new administration.

For one, the administration’s immediate focus is on containing the pandemic and bolstering the economy. Further, with a strongly divided country and slim majorities in Congress, dealing with major tax increases is likely to be a long-term project.

There has been considerable discussion, however, of ways to capture more tax revenue from capital gains.

Biden’s pre-election proposal advocated almost doubling the top tax rate on capital gains from the current 20% (or 23.8% including the Medicare surtax) to a rate equal to that for ordinary income (close to 40% for taxpayers in the top income tax bracket).

Such a large increase seems unlikely, particularly in light of historical evidence that an increase in the capital gains rate often triggers the “lock-in” effect, whereby investors forgo or postpone selling assets with significant embedded gains. Thus less tax is actually collected!

Notwithstanding, given the need for revenue and the focus on income inequality, bumping the rate up to the 25%-28% range would appear likely. Some proposals limit this to only those in top tax brackets or those earning more than $1 million annually.

Equally concerning to the more affluent taxpayers is the possibility that tax increases will be retroactive to the beginning of 2021.

This would mean actions taken now, which under the current tax regime would generate a certain level of tax or possibly no tax, may end up being taxed more heavily by the time 2021 tax returns are due. Retroactive increases are highly unpopular, though, and so quite rare. More often, tax increases become effective at a future date.

 Plan, but Don’t Panic

So, what are taxpayers to do? Now is the time for thoughtful planning. Remember the old but relevant advice not to let the proverbial “tax tail” wag the dog.

History is littered with examples of hastily crafted documents and asset transfers done in front of rumored tax changes, and later regretted.

To guard against the possibility of retroactive changes, it could be prudent to wait until later in the year to complete a transfer.