How Capital Gains Are Taxed and How That Might Change

(Bloomberg) -- Capital gains taxes are the price of making a good investment. They’re levied on profitable stock trades and real estate deals and also can apply to sales of businesses, pieces of art, collectible cars, gold and other assets. With President Joe Biden and fellow Democrats in the U.S. Congress looking for ways to fund increased social spending, raising the capital gains rate for wealthy taxpayers is a front-burner idea, though how far to raise it remains an issue.

1. How are capital gains taxed?

Investors are taxed on the difference between what they paid for an asset and what they sold it for. The U.S. federal rate for investments held at least one year currently tops out at 20%, well below the top marginal rate of 37% on wages and salaries. (Investments held for a year or shorter are taxed the same as wages and salaries.) As with all investments, an additional 3.8% tax applies to capital gains earned by individuals earning at least $200,000, or married couples earning $250,000, to fund the U.S. health-insurance subsidy program known as Obamacare. And a higher 28% capital gains rate applies to transactions involving certain investments in small businesses and in collectibles such as art, antiques, stamps, wine and precious metals. States also tax capital gains but have varying approaches.

2. Who pays them?

Though anybody can have capital gains, it’s generally the very wealthiest of taxpayers who derive the bulk of their riches from capital gains on investments. Capital gains taxes don’t apply to common tax-favored retirement vehicles such as 401(k)s or individual retirement accounts; taxpayers pay ordinary rates on those gains earned in traditional accounts. Some low-income taxpayers don’t pay the capital gains tax at all; individuals earning up to $40,400 pay a 0% capital gains rate this year. Homeowners also get a break. The first $250,000 in proceeds from the sale of a primary residence is exempt from capital gains taxes for a single person, or twice that for a married couple.

3. Are U.S. rates high or low?

The 23.8% top rate (including the Obamacare add-on) ranks among the middle of the pack of countries in the Organization for Economic Cooperation and Development. France, with rates that top out at 30%, has among the highest rates on investments. Some countries, such as Switzerland, have no specific capital gains tax but tax sales at ordinary income rates. Others such as Belgium and Denmark exempt some stock sales held for at least a year.

4. Why are capital gains taxed lower than other income?

Proponents of the lower rate say it rewards entrepreneurship and risk-taking and encourages investors to periodically sell what they own, preventing a so-called lock-in effect. (At least some of those proponents advocate no capital gains tax at all.) Critics say that the spread between how wages and investments are taxed can encourage rate arbitrage, creating opportunities for the wealthy to lessen their tax bills.

5. What’s being proposed?

Biden proposed almost doubling the rate to 39.6% -- the new, higher top marginal income-tax rate under his broader taxation proposal -- for those earning $1 million or more, or approximately 0.3% of taxpayers. Democrats in the House of Representatives proposed a smaller increase in the rate, to 25%, for those in the top capital gains tax bracket, which in 2021 means individual filers earning more than $445,850 and married joint filers earning more than $501,600. (The 3.8% surcharge for Obamacare would still be levied on top of those rates.) The draft House legislation released on Sept. 13 also left out a Biden proposal to end a tax break on inheritances known as “step up in basis,” which wipes out the capital gains tax on assets when the owner dies.

The Reference Shelf

• What’s in the House Ways and Means Committee’s tax plan.
• Bloomberg Opinion columnist Alexis Leondis says a loophole in the Democrats’ tax plan will let the wealthy continue to shelter gains.
• NerdWallet has a capital gains tax calculator.
• Law Firm DLA Piper keeps a running list of capital gain tax rates in different countries.
• The IRS has a user-friendly guide to capital gains taxes and how to pay them.

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