Democrats have made an increase in the capital gains rate a major priority in their upcoming reconciliation tax bill, and the potential effective date is critical for many investment decisions. With tax writers launching mark-ups as early as Sept. 9 and racing against a Sept. 27 deadline, there could be imminent action triggering an effective date tied to an upcoming “date of announcement.”
While the ultimate legislative outcome is far from certain, current Democratic discussions can offer insight to help taxpayers make informed decisions. The following frequently asked questions are based on the latest information on the outlook.
Q: Will tax increases actually happen?
Democrats have now passed a budget resolution with reconciliation instructions allowing them to pass a major tax and spending bill with only 50 votes in the Senate. They have made this bill their top priority and its prospects remain good, but success is far from guaranteed. The legislative process is always difficult. There are deep divisions between moderate and progressive Democrats, and Democrats have almost no margin for error. Without Republican support, Democrats must have complete unanimity in the Senate and can only lose three votes in the House. Democratic leadership is holding up a Senate-passed bipartisan infrastructure bill as leverage to force moderates to agree to a reconciliation tax bill. Moderates, however, refused to vote on the budget until leadership promised a vote on the infrastructure bill by Sept. 27. This deadline robs leadership of some leverage, and Democrats will have to quickly bridge major divides between moderates and Democrats. The current proposals will likely evolve if Democrats are to reach a successful compromise.
Q: What are Democrats proposing on capital gains?
President Joe Biden and many progressive Democrats have proposed taxing capital gains as ordinary income at a top rate of 39.6% to the extent adjusted gross income exceeds $1 million, effective for transactions after an unspecified “date of announcement.” This proposal is aggressive, however, and moderates are likely to force a compromise on a lower rate.
Q: What is the most likely rate?It would be very surprising to see the capital gains rate go higher than 28%. In fact, recent intelligence suggests many Democrats favor a rate increase as low as 4.2 percentage points, which would result in a 24.2% rate before net investment income (NII) tax and a 28% rate inclusive of the 3.8% NII tax. The most likely outcome, if a tax bill is enacted, appears to be a rate increase between 4 and 8 percentage points.
Q: When would a change be made effective?
Democrats have been discussing making a change effective on the date the proposal is formally introduced, or the “date of announcement.” This is designed to prevent taxpayers from selling assets and engaging in transactions ahead of the rate increase, while avoiding retroactively increasing taxes on transactions that occurred before the change was announced. Lawmakers have also discussed “grandfathering” rules for transactions subject to a binding written contract before the effective date. Other effective date options also remain in play. Democrats could settle on an effective date of Jan. 1, 2022, or later if the congressional scorekeepers estimate that a delayed effective date would raise more revenue. Moderates may also be wary of raising taxes too soon while the economy remains fragile.
Q: When will the “date of announcement” come?
The Ways and Means Committee is expected to propose a “date of announcement” effective date when they unveil their capital gains proposal for mark-up, though again, it’s not guaranteed that this date will stick through the legislative process. The House mark-up is currently expected to occur over several days on Sept. 9, 10, 14, and 15, though they have not officially put these dates on the schedule. The actual day of announcement for a capital gains change will be a closely guarded secret beforehand, as members and staff will want to avoid a market-moving leak. The announcement is likely to come after markets close before one of the mark-up days. Sept. 14 and 15 appear to be the most likely proposed effective dates (revenue raisers are likely to be considered last), but it could come earlier.
Q: Is it possible we’ve already passed the “date of announcement”?
The administration has hinted that a “date of announcement” could be tied to April 28 when the American Families Plan was introduced, or May 28, when the Treasury “green book” of revenue proposals was released. While this is not impossible, it seems very unlikely. The administration has not formally put taxpayers on notice based on either date, and the administration does not seem to be actively pushing Congress on this issue. In addition, congressional tax writers will want to tie any effective date to their own action.
Q: How could grandfathering rules be written?
There is discussion of providing transition rules for gain transactions that were subject to a binding written contract or agreement before the effective date, but we cannot be certain that these grandfathering rules will survive or how tightly they may be written. Presumably the rules would require taxpayers to be legally obligated to close on a transaction without conditions. It is also unclear whether these transition rules could apply to installment sales or dividends.
Q: Are there reasons to trigger gain now and is there still time?
Taxpayers can consider triggering gain now at current rates to avoid potentially paying higher rates on the gain in the future. There does appear to be a short window of time to act if the effective date ends up tied to the mark-up from Sept. 9-15. Securities sales in particular can often be accomplished quickly. There is no wash sale rule on gains and securities can be sold and bought back to trigger gain and reset the basis. Please note, however, that there may be considerable risks to gain acceleration strategies, and taxpayers should understand the potential downsides.
Q: What are the risks to harvesting gain now?
There are several potential scenarios in which gain harvesting may not be beneficial: 1. Democrats make the change effective back to April or May (though this seems very unlikely); 2. Democrats compromise on a prospective effective date of Jan. 1, 2022, or later (this is certainly possible); 3. The bill falls apart and there is no capital gains rate increase at all (success on the bill is far from guaranteed). Under each of these scenarios, taxpayers could pay tax early or sacrifice value by rushing a transaction for no rate benefit. The challenge for taxpayers is that a “date of announcement” effective date requires pre-emptive action with incomplete information.
Next steps
Democrats have a unique opportunity to enact transformational tax changes without Republican votes. Although the ultimate outlook is not certain, some taxpayers may benefit from pre-emptive tax planning. Taxpayers can consider triggering gain before the potential effective date of a capital gains change, but should assess the outlook carefully and understand the risk. Taxpayers can also consider other rate arbitrage opportunities as Democrats are largely proposing effective dates of Jan. 1, 2022, or later for most other proposed changes.
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