Proposed changes in capital gains taxes under the Biden administration are worrying investors and their tax advisors, especially the possibility of making them retroactive.

The Treasury Department released its Green Book containing the administration’s fiscal year 2022 budget tax proposals last Friday, which would tax long-term capital gains and qualified dividends of taxpayers with adjusted gross income of more than $1 million at ordinary income tax rates. Under the proposal, 37% would generally be the highest individual tax rate (or 40.8%, including the net investment income tax), but only if the taxpayer’s income exceeded $1 million (or $500,000 for taxpayers who are married filing separately), indexed for inflation after 2022. The Green Book said the “proposal would be effective for gains required to be recognized after the date of announcement.” However, that announcement could be interpreted as the date when the American Families Plan was first announced, on April 28 (see story).

It’s rare for a tax change of this magnitude to apply retroactively, and the possibility will make it difficult for tax professionals to advise their clients on what to do. More often, retroactive tax provisions apply to items like tax extenders that are often assumed will be passed by Congress eventually.

“The mere announcement by the president of the desire for an earlier effective date may take off the table proposed transactions,” said BDO tax partner Todd Simmens, a former legislation counsel for Congress’ Joint Committee on Taxation. “Taxpayers may think, if it really would be retroactive, maybe we’re going to pass on the transaction, whatever that transaction is. That’s an issue because there may be those who were planning to sell or enter into a transaction and relying on the current law rates. That may throw a monkey wrench into that thinking. Going backward, I think the real trouble may be those who may have already started going down the road of a transaction or closed on it. They may have reached an agreement and closed, and a retroactive capital gains increase may directly impact the tax on that transaction.”

The possible retroactivity may be a way of preventing taxpayers from front-running their transactions, as happened with some earlier tax reforms. “Some of the capital gains stuff is hard to imagine,” said Edward Renn, a partner on the private client and tax team at the international law firm Withers, who focuses on wealth preservation, income maximization strategies and international tax planning. “It would really be a tax revolution. Maybe we do get an increased capital gains rate, but I don’t know that it’s going to be as high as ordinary and top marginal income rates.”

Historically, retroactive tax increases have been generally disfavored, Simmens noted. “I’ve always been thinking, in discussing Biden tax policy, assuming we have legislative activity this year, we would be looking at an effective date of Jan. 1, 2022 with some exceptions,” he said. “And capital gains, because they target sales and exchanges, each one of those policies may be appropriate for an exception. However I do think the president was throwing out a marker, letting people know, OK, you may not be able to get away until January. You may not be able to plan around a capital gains increase over the next eight months. It’s going to come sooner, but I’m not sure that the end of April is the sooner.”

Instead of looking at the April 28 date of the American Families Plan, he suggested the date may be the first committee action, such as when the tax-writing House Ways and Means Committee first starts to mark up a bill. “That’s sort of the official start of the legislative process, so to me that might be a time,” said Simmens. “While this first committee action hasn’t happened yet, if you ask me today, we’re probably looking at the fall. But it won’t blindside anybody. I think that the notion of the end of April would blindside taxpayers who really were not trying to plan around the capital gains increase necessarily, but who may have either been in the middle of a transaction — they may have reached an agreement in the winter to close in the summer — there’s just uncertainty with what you do there. Do you look at a binding commitment or do you look at closing? What do you look at for the activity that is subject to the effective date? I think that the end of April would make enough key members of Congress uncomfortable that some other date would be looked at.”

Another option, he noted, could be for transactions (such as sales and exchanges or binding commitments, for example) to be after the date of enactment.

Step up in basis

A related issue of concern is an earlier proposal by the administration to eliminate the step up in basis on inherited assets from a decedent. The Green Book clarifies a number of points, allowing an exclusion of $1 million on capital gains, indexed for inflation, and also excluding transfers by a decedent to a U.S. spouse or charity. The capital gain would not be recognized until the surviving spouse disposes of the asset or dies, and appreciated property transferred to charity would not generate a taxable capital gain.

“The proposal would exclude from recognition any gain on tangible personal property such as household furnishings and personal effects (excluding collectibles),” according to the Green Book. “The $250,000 per-person exclusion under current law for capital gain on a principal residence would apply to all residences and would be portable to the decedent’s surviving spouse, making the exclusion effectively $500,000 per couple. Finally, the exclusion under current law for capital gain on certain small business stock would also apply. In addition to the above exclusions, the proposal would allow a $1 million per-person exclusion from recognition of other unrealized capital gains on property transferred by gift or held at death. The per-person exclusion would be indexed for inflation after 2022 and would be portable to the decedent’s surviving spouse under the same rules that apply to portability for estate and gift tax purposes (making the exclusion effectively $2 million per married couple). The recipient’s basis in property received by reason of the decedent’s death would be the property’s fair market value at the decedent’s death.”

However, the possible changes in the basis rules are still concerning to tax practitioners, even with the Treasury Department’s clarifications.

“The other thing in terms of the loss of step up is a very big deal, because very often given the complexity of the Tax Code with networks and partnerships and LLCs, even with some publicly traded securities from time to time, you’re not really sure what somebody’s basis is,” said Renn. “The one time you used to have absolute certainty about the value of what something was in terms of a basis number was after you got the estate tax return. The presumption is, if you can’t prove the basis, it’s zero. We’re talking about assets that are not going to get stepped up anymore in the traditional sense. How are we going to prove that basis when it’s something that mom and dad owned for 40 or 50 years?”

He noted that Congress did pass a comparable change in the Tax Reform Act of 1976 but found it was unworkable. “When they were discussing the repeal of carryover basis in the 1970s, they actually passed it in the 1976 act, and it floated around for three or four years and then it eventually got killed,” said Renn. “The reason it got killed was it wasn’t considered administratively workable. Nobody had the records. I guess computers are better today than they were 40 or 50 years ago, but I don’t know that they’re perfect.”

He also objected to another proposal related to the treatment of trusts. “The one other thing really high in the bill is this idea of taxing any asset that’s been in a trust for over 90 years,” said Renn. “The idea is that any asset that you put into a trust and you didn’t have a recognition event on that asset for 90 years, they’ll mark it to market in 2030. So anything you put in in 1940 or before, you’ll be taxed on the appreciation between the date of transfer and 2030, and I guess you’ll pay it in 2031 for the 2030 year. Most clients don’t hold assets for 90 years, but it would seem to apply to closely held businesses, vacation homes, ranches, art. You don’t hold onto your IBM for 90 years, but you might hold onto a Matisse.”

Opportunity Zones

Changes in capital gains tax treatment could also affect investors in opportunity zone funds, according to Renn. “Actually, most of my clients, yes, if we get a 43.4% capital gain rate, the opportunity zone will be attractive, but my clients that invested in opportunity zones in 2018, 2019 and 2020, they’re saying, ‘Hold it. Maybe I should pull the plug on this investment because in 2026, I’ve got to pay capital gains at the rate that’s effective at that time. Right now I’d pay a 23.8% capital gain, and in 2026 I’m going to pay a 43.4% capital gain. This project has to do a lot of good things for me to justify doubling my tax rate.’ I actually think initially it will probably have a negative effect on qualified opportunity zones, not a positive one.”

He believes the proposed tax changes might favor small businesses. “The big winner is 1202 stocks, small-business stocks, because they basically told you they’re leaving that alone, so if you can set up an enterprise and qualify as a 1202 small-business stock, the first $10 million of gain when you sell it won’t be recognized,” said Renn. “That’s a big win.”

The impact of the proposals on opportunity zones is unclear. “It could have an impact,” said Simmens. “We have to see what the effective date looks like and who would be impacted and how they would be impacted.”

Potential changes in tax rates could actually encourage more opportunity zone investment. “Depending on whether investors are in the program versus whether they’re thinking of getting into the program, that’s going to impact how people react to the potential change in tax rates,” said Jessica Millett, a partner at the law firm Duval & Stachenfeld who chairs the tax practice group. “Think about it from the perspective of someone, say we’re in 2022, and somebody sells commercial real estate and they have a capital gain. Let’s assume that 1031s [like-kind exchanges] go away — 1031 is no longer an option — and the capital gains rates are higher. Maybe they’re the same as ordinary income rates. Then, all of a sudden investment into a qualified opportunity zone starts to look pretty good because you’re now able to defer paying tax. You’re deferring a higher amount of tax if the capital gains rates have gone up, and the 10-year benefit for an investment in a qualified opportunity fund just got bigger because you’re now excluding more gain. It’s a bigger exclusion because you’re completely avoiding a tax that would be higher at the capital gains rate.”

Opportunity zones could even help investors ride out the possible tax changes.

“It depends a bit on what happens with the tax rates and what happens with 1031s,” said Millett before the release of the Green Book. “If you eliminate 1031s, and you eliminate the basis step up at death and the rates go up, then opportunity zones become your bag of potential options to mitigate the tax consequences. Now, if one of the benefits is going away at the end of 2021, if you invest in a qualified opportunity fund by Dec. 31, 2021, you essentially get a complete forgiveness of 10% of the amount of gain that you initially invested in a qualified opportunity fund. So when your deferral ends at the end of 2026, you only have to include 90% of that deferred capital gain in income. So, putting aside whatever may happen with the tax rate and whatever may happen with 1031s, there’s a built-in benefit that’s expiring at the end of this year, and that’s always been the case since opportunity zones were first created. So the combination of that deferred 1031 deadline with these potential tax changes means that I’m not going to be able to take a vacation in the summer.”

Still, the potential changes in capital gains rates are likely to leave many investors worried. “For anybody who has previously invested in a qualified opportunity fund, I think there is going to be a fair amount of grumbling and unhappiness if the capital gains tax rate goes up,” said Millett. “Let’s say hypothetically somebody invested in a qualified opportunity fund last year in 2020 when the capital gains tax rate was down at 20%. Now when their deferral period ends in 2026, and they have to pay tax at that point, they’re paying tax at whatever the effective rate is in 2026. So they gave up the ability to pay tax at 20%, and now they’re going to have to pay double that in 2026. There’s a calculus to be done, taking into account the time value of money that they got for the deferral, and potentially this 10% basis step up that they got.”

Lingering uncertainties

There are plenty of other issues for tax professionals and their clients to contemplate in the Geen Book proposals, but much remains to be worked out during negotiations between the administration and lawmakers over the legislation that may or may not get passed.

“There’s an awful lot of detail we don’t have,” said Renn. “We don’t know what kind of charities get a carryover basis, one set of charities for gift purposes, and another set of charities for estate tax purposes. We’re not clear on the family investment exclusion. What would that look like with the illiquid assets? Would you actually be able to pay taxes on them over 15 years? It’s not clear. We don’t have the details. This is just a couple of lines without any detail. It’s not any different than any other proposal when it’s being floated, but I think before everybody is worried about mark to market on gift, and mark to market on death. There are lots of other options. We may get carryover basis. We may get a 28% capital gain rate. We may get things that are seemingly far more middle-road than some of the other proposals that are in this Green Book.”

The Green Book provides lawmakers with a starting point for negotiation.

“I’m not saying there won’t be an increase, but there are some possibilities that might be negotiated such as effective date,” said Simmens. “That may be one issue in capital gains that’s negotiated. One thing that the Green Book already has is that it would apply the amount of capital gains subject to the new rate to the extent income exceeds a million. There’s a sort of phased-in approach, but on-the-fence members may want a more phased-in approach. It gives you somewhat of an exemption for the first million, and above that may be subject to the new rate. Some members may say instead of repealing the gains rate for higher-income taxpayers, maybe instead just add another rate such as 25 or 30 or something else that’s negotiated. I could see this happening in a conference committee. Some members are uncomfortable with just simply taking away the capital gains rate.”

Another sticking point in the negotiations is the $10,000 limit on state and local tax deductions in the Tax Cuts and Jobs Act of 2017, often referred to as the SALT cap, which Democrats have long wanted to repeal. “I think there are enough Democratic members in the House that want the SALT deduction put back to what it was, that could slow things down on the House side, with only a five-person majority,” said Simmens.

On the Senate side, with an even split between Democrats and Republicans, he sees much bigger hurdles with Republicans uniformly opposed to any tax increases, and Sen. Joe Manchin, D-West Virginia, coming out against using budget reconciliation to force through a bill.

He believes tax professionals should warn clients about the possible changes and uncertainty.

“I think practitioners are doing what they should be doing,” said Simmens. “At least bring to their clients’ attention what could happen, but it’s hard to advise. It depends on what your client’s scenario is. Each client has their own individual issues. We can’t predict with enough certainty to make any client comfortable, and they all ask us what’s going to happen, when is it going to happen, when is it going to be effective, and we only have what’s out there in the press and in the Green Book, and that’s it so far. We tell our clients these are the things that are being talked about, and are priorities of the administration when it comes to tax policy. The effective date issue with capital gains is a bit of a monkey wrench because that date has passed, so it’s really hard to go back in time and fix that. If you wanted to hedge your bets and think it’s at the first first committee action [or after the date of enactment], you can tell your clients it’s a gamble, or you can be real conservative and say it’s going to go up, so take it into account.”

He believes an individual income tax rate increase likely wouldn’t come until Jan. 1, 2022, if it even got passed by Congress. In the meantime, tax professionals can pass along some traditional advice to clients.

“If you made short-term gains, they would be subject to ordinary rates anyway,” said Simmens. “You’re not looking at the long-term rates. So to the extent you can accelerate that income appropriately into 2021, do it. If you can push deductions into 2022 appropriately, do it. That’s really the kind of advice we can give now, where we are. It’s frustrating because I do think clients expect their advisors to have all the answers.”