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Washington State's New Capital Gains Tax (Part 3 of 3)

| May 03, 2021

Just over a week ago, in the waning hours of the 2021 legislative session, the Washington State House and Senate passed a capital gains tax bill. This is a first of its kind here in Washington. As expected, this has already found a fight in the courts, and so we do not know whether it will go into effect when prescribed. Regardless, we are not here to debate the wisdom, politics, or constitutionality of this bill. Instead, our job is to help you understand it, as it certainly has raised many questions from many of you as it has worked its way through both houses of the Legislature and into the news (where coverage leaves much to be desired).

Knowing we, like you, were not getting the full story from the news media, we took the time to read through the actual bill to garner a better understanding of what’s coming – and thus how to plan for it. Sparing you that effort, here are the key points, followed by some commentary on planning opportunities that will exist.

  1. This tax goes into effect on January 1, 2022. Capital gains realized prior to this date (aka, this year) are not subject to this tax.
  2. The tax rate is 7% (flat).
  3. This tax rate applies to all long-term capital gains in excess of $250,000 per year, with a few key exceptions.
  4. Notable amongst these key exceptions are:
    1. Any real estate transaction (whether it’s your home or an investment property, it does not matter).
    2. Any assets held in a retirement account, including deferred comp plans.
    3. Sale of “qualified” family-owned businesses. More on what qualified means later in this briefing.
    4. Other exemptions include provisions around the sale of timberland, livestock, commercial fishing privileges, and more – but we will not go into detail on those, as we don’t believe they impact many (or any) of you reading this.
  5. Applicable gains are calculated the same way as they are at the federal level, before state adjustments are made. This means that any existing carryforward losses that were generated by activities deemed taxable here will help to reduce your exposure to this tax.
  6. Another very key exception that has not been widely discussed is that this tax does not apply to short-term capital gains (assets held <1 yr). More on that later.
  7. The $250,000 exemption applies to individuals and couples equally. In other words, you get a $250,000 exemption filing as single and a married couple gets the same $250,000 exemption (not doubled to $500,000). If you file as married on your federal return, you cannot elect to file as individuals on this state return in order to double the exemption to $500,000. See illustration below for more on this “marriage penalty.”
  8. The $250,000 exemption will be indexed to inflation in future years.
  9. You can further reduce your tax bill through charitable contributions, but these contributions must be very substantial (>$250,000 in a year). Any amount up to $100,000 contributed in excess of $250,000 can be used to reduce your WA State capital gains bill (e.g. if you donate $300,000, you can take a $50,000 deduction that year).
  10. You do not get a credit for federal capital gains taxes paid on the same gains (same dollar is taxed twice), but you do get a credit for capital gains taxes paid to another state for gains realized and attributable to that state.

If you’re like me, you appreciate a good visual, so let’s take a look at an example of how this tax would apply to two scenarios – one for an individual and one for a married couple. In this example, we have high-earning taxpayers who have a combination of wage income (W2) and capital gains activity from the sale of a primary residence, long-term sale of stocks, and short-term sale of stocks. In both cases, the taxpayers gave $300,000 to charity during the year. Let’s see how this all plays out for each:

Yes, the income and gains numbers are fairly large in this example. That’s an important point. They have to be – as this tax is limited to those with fairly substantial capital gains of a pretty specific type. In other words, many of you need not worry about this tax directly, at least for now. However, for those of you that do, we can work with you and your tax professional to plan for and mitigate (or completely eliminate) any exposure to this tax in a given year. That said, we never want to lose sight of the fact that paying capital gains taxes means you have made money – and we don’t want to lose the forest for the trees and lose out on wealth generating opportunities solely for the purpose of avoiding a tax.

With that, let’s look briefly at a couple of items from above that warrant further definition. First, the term “qualified family-owned small business.” What qualifies it? Turns out they did a good job defining this, though the definition is too long to fully discuss here. In short, these are businesses with <$10MM of annual revenue that you owned all or part of for the past five years and have materially participated in for at least five of the past 10 years (unless the sale is to a qualified heir). You or your family do not have to be the sole owners of the business. There are thresholds of co-ownership that apply, and we’re happy to send you further details on these if you are interested.

Another important item is #5 from our list above. This is the fact that the tax does not apply to short-term capital gains. Reason for this is that short-term gains are treated as ordinary income at the federal level, and thus would likely run afoul of the state’s constitutional prohibition on the taxation of income. So you might wonder if it would be wise to simply sell assets before they turn long-term. Reasonable thought, though in many cases, it will still be advantageous to hold the asset until long-term status is received. Why do I say this?

  1. The combined state and federal rate would likely be 27% (+3.8% net investment income surtax at the federal level). While high, this remains lower than the marginal tax bracket that applies to ordinary income for most of those that need to be concerned about this tax.
  2. Those first $250,000 of gains that are exempt here in WA are still subject to federal capital gains taxes, where you definitely want the preferred rates to apply.

That said, there is a looming issue that may present a tricky road to navigate for the highest earners. That is, if the Biden administration’s proposal to raise long-term capital gains rates to 39.6% on incomes >$1MM ultimately passes, there will be no difference between the tax rates applicable to short-term and long-term gains, at the margins. Here we might find it advantageous to harvest gains on a short-term basis, depending on your personal situation. As is the case with nearly every one of these financial planning briefings we write, there is no blanket advice that fits for everyone. As the rules get more layered and complex, the need for personalized advice only grows. We encourage you to reach out to us and to your tax professional to take a closer look at your own situation. If we don’t hear from you, you’ll certainly be hearing from us in the coming months as we begin planning for this new layer of tax-time fun.

In conclusion, we’ll finish by going right back to where we started – and mention that this new tax has already been challenged in court. It will likely take months to wind its way through, likely finding its way to the State Supreme Court. As it does, at least you’ll now have a better understanding of what they’re arguing about! Until then, we believe it’s wise and prudent to plan as if this will go into effect next year – while at the same time not making rash decisions that could hurt you in the long-term. We look forward to talking more and will certainly keep you posted if/when things evolve with this fresh new tax.

This concludes our three-part series on capital gains taxes. You are either thanking us for finally shutting up or thanking us because you learned a thing or two. Whatever camp you’re in, we thank you for reading and for your partnership. Here’s to a great week ahead.