Capital Gains: A Century-Old Tax Break Gets a Rush of Attention

Then in mid-June, a New York Times article reported that the private-equity industry, through clever planning and political muscle, can often treat its managers’ compensation as long-term capital gains. That could reduce their top income-tax rate from 37% (plus payroll taxes) to 20%.

This torrent of attention makes it a good time to review the complex, highly charged topic of income taxes on capital gains, especially as current proposals could affect some filers who aren’t among the wealthiest.

For a century the U.S. tax code has given favorable treatment to investment profits called capital gains, in part to compensate for investment risks. Capital gains are the difference between the original cost (plus adjustments) and the selling price of assets such as stock shares or real estate, if there’s a profit. If you buy stock for $5,000 and sell it for $30,000, you have a $25,000 capital gain.

Over time the income-tax rates and rules for capital gains have varied. Under current law, long-term gains—those on investments held longer than a year—are eligible for rates topping out at 23.8%, while the top rate on wages reaches 40.8% when a 3.8% Medicare tax is included.

Also for a century, the tax code has exempted capital gains at death from income tax, a benefit known as the “step-up in basis.”

For example, say that Robert has stock worth $100,000 that he bought for $10,000. If he sells it before he dies, he’ll owe up to $21,420 of federal tax on his $90,000 gain. But if he dies without selling his income tax will be zero, leaving more for heirs. Although Robert’s estate could owe estate tax on the full $100,000 value of the shares if his assets exceed $11.7 million (in 2021), this levy can often be reduced with planning.

Long-term gains also have other tax advantages, such as the ability to reduce or eliminate income from taxable gains by deducting capital losses on unprofitable investments.

But the most powerful benefit of capital gains, say tax specialists, is that investors can choose when to have taxable income by timing their sales—and that could be never, if they hold assets until death. Wage earners don’t have this ability. To obtain cash while alive, some investors avoid sales that trigger taxes by borrowing against their assets.

The tax deferral on unsold assets boosts their growth and usually helps more than inflation hurts, according to tax specialists Len Burman of the Tax Policy Center and

Kyle Pomerleau

of the American Enterprise Institute.

“This result is counterintuitive to a lot of people, but it’s true,” says Mr. Pomerleau.

Both Mr. Burman and Mr. Pomerleau advocate taxing capital gains at the same rates as ordinary income such as wages, although Mr. Pomerleau would couple this with a full deduction for savings. A key outcome of the 1986 tax overhaul, when Mr. Burman was a staffer in Ronald Reagan’s Treasury Department, was a top rate of 28% on both types of income, but it lasted just a few years.

Today these advantages make long-term gains highly desirable to those who can have them, and that’s often the very rich. According to estimates by the staff of Congress’s Joint Committee on Taxation, filers with $1 million or more of income, about 715,000 taxpayers, will report nearly 70% of total long-term gains this year. That’s about $800 billion of income.

These top earners pay lots of taxes. The Committee staff estimates they’ll pay 53% of total income taxes in 2021, which includes tax on income other than capital gains, and income taxes provide nearly half of U.S. revenue. If payroll taxes like Social Security are included, this percentage drops because most of them are paid by people earning less than $200,000. Overall, filers earning $1 million or more pay 27% of U.S. income, employment and excise taxes.

Some critics, such as the writers at ProPublica, say this isn’t enough because the assets of the wealthiest are growing far faster than their income. A major reason for the disparity is that taxpayers don’t have capital-gains income on assets they don’t sell, prompting politicians like Sens. Elizabeth Warren and Bernie Sanders to push for a tax on wealth.

President Biden’s current proposals don’t include a wealth tax, but they do raise rates on long-term gains. To provide more funding for social programs, the administration wants to boost the top rate from 23.8% to 43.4% on income above $1 million for sales after late April, 2021.

The proposals would also end the tax exemption for capital gains at death. Instead, each individual would get an exemption of $1 million plus $250,000 of gain on a home. Above that amount gains would be taxable, effective for deaths after 2021. This change could increase market efficiency by reducing the “lock-in effect” caused by investors who refrain from selling to get the step-up.

These changes plus some others would raise taxes substantially for the highest earners: The Tax Policy Center estimates that about one million tax filers with income between $817,000 and $3.6 million would owe an average of $43,000 more tax for 2022, and 120,000 households with income above $3.6 million would owe an average of $1.3 million more.

But the proposals would also affect taxpayers with income below Mr. Biden’s stated threshold of $400,000 for tax increases, such as those with highly appreciated, long-held assets like a home in a high-cost area, stock or land.

“A 43.4% capital-gains rate is rather terrifying for seniors who bought homes 30, 40, or 50-plus years ago in areas like Boston, where homes are pricey, and would now like to sell,” says Mary Kuhns, a retired systems analyst living in Brookline, Mass., in a house she and her husband bought 42 years ago.

It’s hard to know how many such people there are. Using data from the Federal Reserve, Tax Policy Center specialist Robert McClelland estimates there are roughly 350,000 filers age 70 and older with income below $400,000 but enough capital gains on unsold assets to qualify for the higher rates if they have the same amount of assets at death. If the exemption is doubled to $2 million per individual, about 150,000 filers could be affected.

There’s no telling what changes, if any, will ultimately make it through Congress. Stay tuned.

Write to Laura Saunders at laura.saunders@wsj.com

Corrections & Amplifications
Mary Kuhns and her husband bought their house 42 years ago. An earlier version of this article incorrectly said they bought it 47 years ago. (Corrected on June 18.)