Tax Reform 2021 – Build Back Better: Surcharge on High Income Taxpayers and its Impact on Capital Gain Rate Taxes and Planning

A provision that burst upon the scene in the current version of the proposed Build Back Better Act (BBBA) legislation (not discussed in earlier versions of tax proposals offered by Democrats and the Biden Administration) is Act Section 138206 which would add a “Surcharge on High-Income Individuals, Estates, and Trusts” under what would become Section 1A of the Internal Revenue Code.

Under current law, there is no surcharge (though the net investment income tax may come close in some respects) assessed on individuals, estates, and trusts with income exceeding certain levels.  

The surcharge would be assessed at 3% of income exceeding “modified adjusted gross income” (defined for this purpose as “adjusted gross income reduced by any deduction (not taken into account in determining adjusted gross income) allowed for investment interest expense”.  The surcharge is scheduled to kick in for applicable taxpayers as follows:

It appears that tax-exempt municipal bond income will not contribute to modified adjusted gross income as currently defined.  While many high earners use municipal bond interest income to minimize taxes, this income exclusion does not yet appear to be targeted by legislators looking for additional tax revenue at this time.    

The proposed BBBA legislation also increases the highest tax rate on capital gain income (including qualified dividend income) from 20% to 25% (down at least from the 37% to 39% range proffered in earlier proposals by the Biden Administration).  The capital gain tax rate under the proposed legislation is generally scheduled to kick in for applicable taxpayers as follows:

Capital gain on collectibles will continue to be taxed at 28% and unrecaptured Section 1231 gain will continue to be taxed at 25% under the current proposal.  

The Tax Foundation notes that the top marginal capital gains tax rate would reach 31.8% (combined rate on capital gains plus the net investment income tax rate plus the surcharge tax rate) at the federal level which would be the highest federal tax rate on capital gains since the 1970s.  Combined with state tax income tax rates, this would place the combined federal and state tax rate on capital gains in the mid-30% range and at more than 40% in some states (Oregon, New Jersey, California, New York, Vermont, and Minnesota).  

This combined rate is causing concern among some investors.  Nancy Skeans, CEO of Schneider Downs Wealth Management Advisors notes that “there are always concerns and questions from our clients when taxes go up on individuals.  However, if the proposed increases pass (and that is a big if), it won’t impact most individuals, especially individuals who have retired and don’t have large W-2 or business income.  Our clients who are impacted will probably not see the impact annually but in years where they experience large capital gain transactions.  That being said, it is so important for individuals to work with investment advisors who understand the tax laws and who make tax efficiency in portfolios and tax planning a top priority for their clients.”    

Note however that different effective dates can impact the tax rate on gains (and on dividend income) realized.  The current effective date for the increase in capital gains tax rate is September 13, 2021 (Note: losses incurred after 9/13/2021 appear to effectively reduce gains realized prior to 9/13/2021).  There is a proposed transitional rule for binding contracts entered into prior to September 13 and closed before December 31, 2021.    

The current effective date for the surcharge tax is December 31.  This effective date provides taxpayers with an opportunity for a limited time only to close on capital gain transactions before December 31 to avoid the imposition of the 3% surcharge tax that begins on January 1, 2022.  

Finally, don’t overlook other capital gain deferral strategies available (legally) to reduce taxes that are not currently under the “tax avoidance” or “not paying a fair share of tax” microscope of many legislators. 

Capital Gain Deferral Strategies Available

• Using the like-kind exchange rules for sales of real property. 
• Reinvesting capital gain proceeds into qualified opportunity zones for a limited exclusion of capital gains reinvested before December 31, 2021.  
• Reviewing a portfolio at least annually to trigger transactions on investments with substantial unrealized depreciation to offset realized capital gains will continue to be important (while avoiding wash sale treatment).
• Charitable donation of appreciated securities.  

For owners of small businesses, the ESOPs rules under Section 1042 and eligible qualified small business stock rules under Section 1045 may also provide options to defer the recognition of capital gain at the proposed higher tax rates.  

We will continue to monitor developments as these proposed changes move through the legislative process.  Additional articles and analyses will be provided in the coming weeks.  In the meantime, if you have any questions, please reach out to your Schneider Downs tax consultant or contact us at [email protected].