Navigating Washington State’s New Capital Gains Tax
The newly approved Washington state capital gains tax presents new challenges in tax and estate planning for high-net-worth individuals and families. If you are intending to sell a long-term investment, planning is critical to minimize your capital gains tax. Here’s an overview of what you need to know when considering your options:
Overview of Tax:
- Beginning January 1, 2022, Washington state has instituted a 7% capital gains tax on long-term capital gains above $250K.
- The tax is imposed specifically on long-term gains from the sale or exchange of capital assets.
- There are a handful of assets that are excluded from this tax. Most notable are real estate, assets held in retirement accounts, and interests in qualified family-owned small businesses.
- As of the date of this article, there are two lawsuits challenging the constitutionality of this tax.
Potential Tax Mitigation Strategies:
- Accelerating realization of gains to 2021
- Selling assets over multiple years to keep realized gains below the $250K deduction (i.e. “gains smoothing”).
- For large capital gains ($250K to $1M), consider gifting between $250-350K to a Washington-based non-profit; Every dollar between $250K and $350K that is gifted would be deductible against the Washington State Capital Gains Tax.
- For very large gains ($1M and above), consider transferring intangible property to incomplete gift, non-grantor NING (NV) or WING (WY) trusts and have the asset sold by the trust.
WHAT IS THE NEW CAPITAL GAINS TAX IN WASHINGTON STATE?
The 2021 Washington State Legislature recently passed a new 7% tax on the sale of long-term capital assets (including stocks, bonds, business interests, or other investments) if the gains exceed $250,000 annually. This tax applies to individuals only, though individuals can be liable for the tax as a result of their ownership interest in an entity that sells a long-term capital asset.
WHAT ASSETS WILL BE SUBJECT TO THIS NEW TAX?
The tax is imposed specifically on long-term gains from the sale or exchange of capital assets. Thus, ordinary income, short-term capital gains, dividends, and interest are all excluded from the tax. Certain categories of assets are also excluded, most notably real estate (whether held directly or through a privately owned entity). Other exclusions cover assets held in retirement accounts, and interests in qualified family-owned small businesses.
A “family-owned” small business is defined in the legislation as one that has $10 million or less in gross worldwide receipts in the 12 months immediately preceding the sale. A qualifying sale involves 90% or more of the assets of the business, or 90% or more of the individual taxpayer’s interest in the business.
An annual standard deduction of $250K is available to each individual and married couple (unlike federal law, married couples are not allowed a higher shared amount). An additional $100K deduction is allowed for charitable contributions above $250K made to a Washington-based non-profit. The 7% tax rate is applied to capital gains exceeding the deductible amount, with a limited credit available to the extent income or capital gains taxes are paid by the taxpayer to another state.
WHEN DOES THE NEW CAPITAL GAINS TAX GO INTO EFFECT?
The tax takes effect on Jan. 1, 2022. The first returns will be due in 2023 on capital gains recognized during the calendar year 2022.
HOW WILL THIS NEW TAX BE REPORTED AND PAID?
Only individuals owing capital gains tax are required to file a capital gains tax return, along with a copy of their federal tax return for the same taxable year. The capital gains tax return is due at the same time as the taxpayer’s federal income tax return is due. Taxpayers who receive a filing extension for their federal income tax return are entitled to the same filing extension for their capital gains tax return. However, a filing extension does not extend the due date for paying the capital gains tax due.
HOW DOES THIS COMPARE TO OTHER STATE INCOME TAXES?
Very few states impose taxes specifically on capital gains; however, many states impose personal income taxes on residents and certain non-residents. Such taxes typically encompass capital gains earned by residents, and in many cases also encompass gains earned by non-residents on sales of real estate located within the state.
Many states’ personal income tax rates are graduated such that little or no tax is imposed at lower income levels and the highest rates are paid by only a fraction of the population. For example, California tax rates on married couples range from 1% on the first $17,864 of taxable income to 13.3% on taxable income over $1 million.
The Washington tax appears to be unique among states in that it is imposed solely on long-term capital gains and has a very high standard deduction so that less than 0.1% of state residents will likely pay the tax in any given year.
WHAT IS THE CONTROVERSY AROUND THIS TAX?
Opponents of the capital gains tax have argued (both prior to and since its enactment) that the tax violates the Washington State Constitution. Specifically, the state constitution requires taxes on property to be uniform (i.e., a single tax rate on all property of the same class) and limits the tax rate to 1%. Since income is considered a form of property under Washington case law, if the capital gains tax is deemed to be an income tax, it would violate both of these provisions.
According to the state legislature, the tax is an excise imposed on the sale or exchange of capital assets. By characterizing the tax as an excise or privilege tax, rather than a tax on income, the legislature is attempting to avoid the constitutional issue.
Two lawsuits challenging the tax have been filed in Douglas County. Each suit asks the court to prohibit the state from assessing the tax until the case is decided. Other suits may follow.
WHAT CAN I DO TO AVOID THIS NEW CAPITAL GAINS TAX?
For those who are planning to sell an asset that would be subject to the new Washington state capital gains tax, and the gain exceeds $250K, consider accelerating that sale into 2021, instead of waiting until 2022. Considering the proposed increases in capital gains rates at the Federal level, accelerating gains into 2021 could have benefits beyond simply avoiding the new tax in Washington.
For those who have highly appreciated assets, but are not yet ready to sell, they may be able to avoid the tax by “smoothing” capital gains. For example, if one were to spread sales over multiple years to keep their realized gains below the $250K deduction in each year, they would avoid having any of their gains subjected to the tax.
Another solution that may appeal to some is using charitable giving as a way to reduce exposure to the tax. Every dollar that a taxpayer donates above $250K can be deducted up to a maximum of $350K. However, these donations must be made to Washington charities to qualify. It is important to note that charitable donations below $250K do not have any impact on this tax.
Lastly, taxpayers who are in the top tax bracket and have very large gains may be able to establish a trust in a state without income taxes. An example of this is a Nevada Incomplete Gift Non-Grantor Trust (AKA NING Trust). This strategy entails setting up a trust in a state like Nevada, that does not impose an income tax, and transferring appreciated assets to the trust. When the trust sells the assets, they would not be subjected to taxes in the state of Washington since they are not held by a Washington-based entity. Given the unfavorable tax treatment of trusts, as well as the costs associated with establishing and administering a trust, this method is only appropriate for those with very large gains who are already in the highest tax bracket.
The appropriate strategy will depend largely upon a taxpayer’s unique circumstances, making it critical to incorporate a professional who can assist you with navigating these nuances. For additional questions, please don’t hesitate to contact your Coldstream team.