Life Changes and Capital Gains Hikes: It’s Complicated

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Thinking of selling your home? Getting a divorce? In line for an inheritance? All of this could get more complicated, and costlier, with President Joe Biden’s proposed capital gains tax increase.

Key Takeaways

  • President Biden has proposed increasing the top tax rate on long-term capital gains to 39.6%, up from 20% now.
  • Biden has said that only the wealthiest 0.3% of American households would be affected, but tax experts warn that more people could end up paying more taxes.
  • Life transitions like selling a house, getting a divorce, and even dying could end up being particularly costly.

To help pay for the spending in the American Families Plan and make the wealthy “pay their fair share,” Biden is proposing to raise taxes, including those on long-term capital gains, which affect sales of assets like stocks and real estate that an owner has held for at least a year. The president wants to raise the top federal rate for long-term gains, which would apply to households making at least $1 million, to 39.6%, about double the current 20%. 

The increase in the capital gains rate is part of a broader plan of tax reform meant to raise funds and make the tax system more fair, according to the Biden administration. Besides changes for capital gains, Biden’s plan calls for the top marginal income tax rate to go up, also to 39.6%, which would be an increase from 37% now. 

Biden said that the proposed change in the capital gains tax would affect only the top 0.3% of American households. Some tax experts disagree, however, pointing out that the plan could ensnare more people, particularly if they sell a house, get a divorce, or inherit assets. 

Changes in the tax law may come as an unwelcome surprise for people on the cusp of “life transitions,” said Garrett Watson, senior policy analyst at the Tax Foundation. “This could cover a larger population because many folks could hit” that $1 millon threshold in certain years, he said. 

For those taxpayers who do hit that mark, the capital gains rate of 39.6% is not the end of the story. There’s an additional 3.8% Obamacare surcharge—called the Net Investment Income Tax (NIIT)—on both the current and the proposed rates. So the new top federal rate would effectively be 43.4%, up from 23.8% now. In some places, state and local capital gains taxes could push the combined rate even higher, possibly above 50%.

Taxpayers who make less than $1 million would continue to pay the current long-term capital gains rates, with the top rate at 20% plus the NIIT. (Short-term capital gains, on investments held for less than a year, are taxed as ordinary income, and there are no plans to change that.)

Selling a House

One of the life transitions Watson mentioned that could trigger higher capital gains and put taxpayers over the $1 million threshold is selling a house, especially in markets where housing appreciation has been strong.

For example, newlyweds who bought a house in California 20 years ago for $200,000, raised their kids there, and are ready to downsize, could now be sitting on a home worth $1.5 million. Sounds great, right? Sure, but not as great if the capital gains rate doubles.

If that happens, half a million dollars of gain in the home could be excluded from the couple’s income, but that would still leave $800,000 in gains, which could easily push their income above $1 million for the tax year, making a portion of the gain subject to the top rate.

For people who are divorcing, the scenario becomes even more complicated. 

Although couples are likely to be under a lot of stress and anxious to get the divorce over with, this is no time to be careless about the tax implications of selling a house and dividing assets, said Sheryl Rowling, head of rebalancing solutions at Morningstar.

Rowling advises couples to take a deep breath and try to sell while they are still married. That way, the couple can file their income taxes jointly and still exclude $500,000 of capital gains, the maximum allowed, from the sale of the house. On the other hand, if one spouse gets the house in the divorce and then decides to sell it later—as a single tax filer—they would be able to exclude only $250,000 of the capital gains.

Death and Taxes

Dying isn’t cheap, and it would become even more expensive for some if the president’s proposals come to fruition. Biden wants to close a loophole involving so-called death taxes—estate and inheritance taxes—that he says allow the wealthiest Americans to escape taxes by passing down assets to their heirs tax-free. 

The loophole is the so-called step-up basis, which values inherited investments at their current market value at the time of death, instead of at the price that was originally paid. These investments, including real estate, stocks, artwork, and other property, may have appreciated significantly over time. Because of the step-up rule, people can inherit such assets and, even if they sell them, end up paying no tax or paying tax only on a small portion of appreciation.

The criticism is that this rule not only allows people to inherit wealth tax-free, but it guarantees that no tax will ever be paid by anyone on much of the investment gain, reducing the amount of tax the government collects. 

Under Biden’s proposal, unrealized capital gains of more than $1 million, dating from the time of purchase of the asset, would be taxed at the time of death, and the tax would apply whether the heirs sell the asset or not. 

That would mean that people who inherit a house, for example, would owe capital gains tax on the amount the house has gone up in value, even if they don’t want to sell it. “This could pose a real issue,” Rowling said. “It could leave people in a position to have to sell family homes to pay the tax.”

Although Biden’s plan allows for the tax payments to be spread out over 15 years, an “ongoing tax bill with the IRS over a decade or so isn’t really great,” Watson said.

Farms and family-owned businesses would be exempt from the new rules under the Biden plan, so that these assets could remain in the family and continue operating.

Be Prepared, One Way or Another

One tricky part of trying to prepare is that Biden has indicated that the capital gains tax would be retroactive to the date of its announcement. There is some debate about whether that date would be April 28, when Biden issued a fact sheet about his plans, or May 28, the day the White House made a formal announcement.

“People who are planning right now have to position themselves to assume the capital gains changes will be applicable this year,” Rowling said.

Even so, there is no way to know yet what parts of the administration’s capital gains tax proposal, if any, will pass in Congress. For example, experts question whether Biden’s plans related to death taxes will fly. 

“Such a reversal of long standing tax policy will be tough to pass,” Rowling said. “Maybe there will be a compromise with higher limits, some change in the exemption numbers. ...It’s all up for discussion and negotiation.”

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  1. U.S. Treasury. “General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals.”

  2. White House. “Fact Sheet: The American Families Plan.“

  3. Internal Revenue Service. “Find out if Net Investment Income Tax applies to you.”

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