By Kelly Phillips Erb
Think we’re finished with tax breaks in 2018? Not so fast. Hot on the heels of tax cuts from the Tax Jobs and Cuts Act (TJCA), Congress is already looking at another round of changes that they’re calling Tax Reform 2.0. But, like a late-night infomercial, there’s more: The Trump administration is considering a change to the way that we tax capital gains, which some equate to a tax cut. The controversial move wouldn't specifically cut capital tax gain rates but would index the rates for inflation (keep reading, I'll explain more about how it works in a bit).
Capital gains taxes were not lowered as part of the TJCA, likely because of the cost and the audience: Lowering capital gains taxes would primarily benefit high-income taxpayers. With Congress already hearing an earful from constituents about cuts targeting wealthy, they were anxious to prove that tax reform would help the middle class.
That doesn’t seem to concern the President. Secretary of Treasury Steven Mnuchin told the New York Times that the White House is contemplating making changes to the way that we tax capital gains worth $100 billion - without Congressional approval. The move is likely to win support from investors, but stoke ire from fiscal hawks who are already worried about a rising federal deficit. The Congressional Budget Office (CBO) predicts that the federal deficit will reach $804 billion for the 2018 fiscal year, a $139 billion increase over last year. The CBO projects that budget deficits will continue to increase, from 4.2% of GDP this year to 5.1% in 2022, a percentage that has been exceeded in only five years since 1946. According to the CBO, the TCJA, the Bipartisan Budget Act of 2018, and the Consolidated Appropriations Act are to blame, since they have “significantly reduced revenues and increased outlays anticipated under current law.”
Adding to those numbers isn't popular. But not everyone believes that a change to the way we tax capital gains would result in a larger deficit. According to Ryan Ellis, president of the Center for a Free Economy, “If homeowners, businesses, and investors are allowed to take inflation out of their taxable gains, it will immediately unlock potentially trillions of dollars in asset sales that otherwise never would have happened. That in turn triggers capital gains taxes paid that never would have been paid absent this change.” With that, he says, “I have zero concern about federal revenue as a result.”
So what would the change look like? First, a quick primer on capital gains. For tax purposes, capital gains and losses are calculated by determining how much your cost basis has gone up or down from the time you acquired the asset until there's a taxable event. Basis is, at its most simple, the cost that you pay for assets. The rate of tax that you pay depends on whether those gains (or losses) are long-term or short-term.
If you hold a capital asset for one year or less and then sell or otherwise dispose of it, your capital gain is considered short-term. Short-term gains are generally taxed at your ordinary income tax rate (you can check the 2018 tax rates here).
If you hold a capital asset for more than one year before you get rid of it, your capital gain is called long-term. Long-term gains are subject to more favorable rates. For 2018, the highest tax rate on a net long-term capital gain is 20%.
Here’s a quick example:
Let’s assume that you're in a 24% tax bracket, and you bought a share of stock on July 31, 2017, for $100. If you sold the stock on July 1, 2018, for $250, your capital gain is $150, or $250 (selling price) less $100 (purchase price, or basis). Since you held the asset for less than one year, it's a short-term gain. Your tax on the sale would be $36, or $150 taxed at 24% (your ordinary income tax rate).
But what if you waited until August 1, 2018, to sell the stock? Let’s say that it was still worth $250 at that time. Your capital would still be $150, or $250 (selling price) less $100 (purchase price, or basis). But, since you held it for more than a year, it’s a long-term gain. Your tax on the sale would be $22.50, or $150 taxed at the lower capital gain rate of 15%.
(You can find out more about tax and capital gains here.)
The actual cost is sometimes referred to as "cost basis" because you can make adjustments to basis over time. For example, if you add to the asset, either as a new purchase or a reinvestment, your basis is your cost plus the cost of each subsequent purchase/reinvestment. But you don't have to add to or improve an asset for it to be worth more when you sell it. Assets like real estate, stock, and cryptocurrency may increase in value for all kinds of reasons, including inflation. For example, an asset bought in, say, 2000, might be more valuable today just because of the passage of time.
That increase is what the White House is targeting in its proposal. Specifically, the administration is considering indexing capital gains by taking inflation into account. In other words, only gains which exceed the rate of inflation would be subject to tax. That, according to Ellis makes sense. “People should not have to pay taxes on merely inflationary gains,” he says. “It’s not fair, and it’s totally reasonable that your basis can be defined in today’s dollars.”
However, co-founder of the Tax Policy Center and Forbes contributor Len Burman argues that capital gains are already less burdened by inflation than other forms of capital assets. Since capital gains aren’t taxed until you dispose of an asset, he says, “inflation is a smaller portion of your gain than it is for income that is taxed annually such as interest, rents, and dividends.”
Additionally, Burman calls the proposal “extremely regressive,” noting that, “[v]ery rich people hold most assets with capital gains.” By dollars, more than 75% of capital gains tax are paid by taxpayers reporting income over $1,000,000. Just over 1% of capital gains taxes are paid by taxpayers reporting income of $100,000 or less. “Therefore,” writes Burman, “the most well-off would reap the largest benefits from a policy change to index the basis of capital assets.”
(You can see a chart of capital tax gains by income level and read Burman’s complete analysis for Forbes here.)
If the White House moves forward with a plan to alter the capital gains tax, there’s no guarantee that it will stick. Under the Constitution, the responsibility for tax law belongs to Congress. It’s not a certainty that the President has the authority to do so on his own, which could lead to a challenge in court. Ellis, however, isn’t worried. "This isn’t about cutting the capital gains tax,” he says. “Only Congress can do that. This is about the Treasury Department taking the inflation tax out of the capital gains tax via a common sense definition correction.”