Proposed policy changes to capital gains and the net investment income tax

The third-party tax agenda

The third-party tax agenda

Abstract:

Most of the discussion between Democrats and Republicans on capital gains taxes is about the appropriate tax rate. The third-party tax agenda considers the economic impact of changes in rates along with several other policy levers.

· Does higher tax rates on capital gains discourage assets sales?

· What is the best ratio of the capital gains and net investment income tax rate?

· Should the tax base for net investment income taxes be expanded?

· Should 1031 exchanges be eliminated or modified?

· Can modifications to capital gains and net investment income tax rates stimulate increased sale of principal residences?

Introduction:

Most of the policy discussions between Democrats and Republicans on capital gains and the net investment income tax center on the appropriate tax rate. Not surprisingly, Democrats advocate for increases in tax rates and Republicans for lower rates. However, the debate on capital gains and net investment income tax is far more complex than a debate on where to set the tax rate.

· Higher capital gains tax rates are projected to increase revenue, however, selling an asset is optional and higher rates will discourage the sale of assets thereby reducing capital gains realizations and income subject to the net investment income tax. To what extent would higher capital gains tax rates reduce capital gains realizations and net investment income?

· A portion of all capital gains income is included in taxable income. By contrast, net investment income for individuals with modified adjusted gross income below a certain threshold is not taxed. What is gained by subjecting all people to capital gains taxes and exempting some people from the net investment income tax? Should all people with net investment income be subject to the net investment income tax?

· The taxation of capital gains is viewed as highly progressive because a disproportionate amount of capital gains taxes is paid by rich people with assets. However, people are most likely to sell assets and realize gains when they are most in need of funds. Is it desirable from a public policy viewpoint to tax people when they most need money?

· The step up in basis at death creates an incentive for older taxpayers to forego asset sales. Is this incentive good public policy?

· Homeowners with large gains in their principal residence often forego downsizing and moving because of the additional costs from the capital gains tax and the net investment income tax. This has reduced the supply of houses on the market and reduced real estate activity. What changes to capital gains and net investment income taxes would stimulate additional real estate activity?

· Property owners often avoid capital gains through a 1031 exchange. What are the ramifications of the eliminations or modification of 1031 exchanges on real estate markets and on the treasury revenue?

The purpose of this memo is to outline policies, which expand the tax base subject to the capital gains tax base and increase capital gains realizations.

Proposed Policy #1: Reduce taxes on capital gains while increasing and expanding the net investment income tax.

Possible Change:

· Establish a top rate on capital gains of 15 percent.

· Increase the net investment income tax rate to 5.0 percent.

· Reduce income thresholds governing when the net investment income tax kicks in by around 30 percent.

Analysis: Revenue from the net investment income tax are earmarked to the Social Security Trust fund while revenue from the capital gains tax rates are earmarked to general government expenses. This proposed policy reallocates resources to the Social Security trust fund, thereby, reducing and/or delaying potential reductions in Social Security benefits. The proposal also increases the discretionary or non-entitlement budget deficit, which would increase pressure for additional spending reductions.

Proposed Policy #2: Apply a relatively small tax on unrealized capital gains administered at death.

· The proposed tax rate on capital gains at the death of the individual would be around 1 percent to 3 percent of unrealized capital gains.

· Heirs would continue to receive a step up in basis after paying the tax on unrealized gains.

Analysis: The existence of the tax on unrealized capital gains upon death could encourage some taxpayers to sell assets and take capital gains while they are alive.

Some investors are reluctant to alter or rebalance their portfolio to avoid capital gains, resulting in insufficient diversification. Consider the financial exposure stemming from the fall in energy stocks in 2014 or the frequent corrections in tech stocks after a period of robust gains.

A tax on unrealized gains at death would encourage some investors to sell assets to rebalance their portfolio.

An alternative way to increase and speed up gain realizations would involve eliminating the step up in basis upon death.

Proposed Policy #3: Reduce the capital gains tax rate on sale of principal residences.

Possible change:

· Establish a top rate on capital gains for the sale of a principal residence of 10 percent

Analysis: Even though a portion ($250,000 for single taxpayers and $500,000 for married taxpayers) of the capital gain on the sale of a personal residence is exempt from capital gains taxes, the capital gains and net investment income tax on the sale of a principal residence can be substantial and can often dissuade homeowners with large gains from putting their house on the market. The taxable gain is especially large for older homeowners who have been in the same home for a long period. Moreover, older homeowners have a strong incentive to remain in their current home so their heirs could receive a step up in the basis for future capital gains

People selling a home must generally repurchase another one, and a large tax on the gain on top of moving expenses and closing costs on a new home can make moving costly. This tax change would increase the inventory of homes available and facilitate purchases by younger homeowners and first time buyers.

Note: The sale of some expensive homes by people with large gains could lead to multiple other housing transactions depending upon where people move. Consider the case where people in a high-end house expensive market move to a less expensive market, creating a move-up move in the high-end market and an opportunity for first-time buyers in the high-end market.

Proposal 4: Eliminate 1031 exchanges

· The elimination of 1031 exchanges would prevent people from deferring capital gains taxes on investment properties.

Analysis: A 1031 exchange allows investors to defer capital gains on the sale of one investment property by reinvesting the proceeds into another like-kind property. The elimination or phase out of 1031 exchanges increases the number of transactions subject to capital gains taxes and net investment income tax. The use of 1031 exchanges to avoid capital gain and net investment income taxes would increase if the capital gains tax rate was increased. The elimination of 1031 exchanges combined with a reduction in capital gains tax rates would substantially increase taxable transactions.