The rich benefit as Democrats retreat from tax on unrealized capital gains

Democrats seem to have nixed the idea of taxing returns on unsold stock and other assets, favoring other ways to raise revenue as part of a nearly $2 trillion social and climate bill.

Scrapping that tax on “unrealized capital gains” would primarily benefit the richest Americans, who hold the bulk of the country’s financial wealth.

The U.S. tax system is designed to tax income, like wages from a job. But stock and other asset gains don’t count as income unless sold, or “realized.”

That means asset owners can delay tax by holding onto the asset for years. They can sometimes escape tax outright if they keep an investment until death, due to tax rules for inheritances.

These workarounds lead many of the country’s wealthiest people to underpay their fair share of taxes, according to Richard Winchester, a tax policy expert and associate professor at Seton Hall Law School.

“The uber-wealthy can manipulate the timing of their tax bill, and they manipulate it in a way where it never ever comes,” Winchester said.

Almost all households (98%) in the top 10% have some sort of unrealized gains, according to most recent Federal Reserve data, from 2019. Those gains may be from assets like a home, vacation property, business, stocks and mutual funds.

By comparison, about 40% of families in the bottom 20% have unsold, appreciated assets.

And the value of their unrealized gains differs significantly — about $100,000 for the bottom 20% versus $1.7 million for the top 10%, on average, according to the Federal Reserve.

More from Personal Finance:
More employers put 401(k) savings on autopilot
Here are the 10 best cities for ringing in 2022
More Americans took on holiday debt this season

The top 1% gained more than $6.5 trillion in corporate stock and mutual fund wealth during the pandemic-era market boom, according to the latest data from the Federal Reserve. The bottom 90% added $1.2 trillion.

Unrealized capital gains are also concentrated among white households, according to the Institute on Taxation and Economic Policy, a left-leaning think tank.

About 89% of gains over $2 million are held by such households, versus 1% each for Black and Hispanic families, according to the group’s analysis of Federal Reserve data.  

Wealthy households don’t necessarily need to sell appreciated assets to fund their lifestyles. For example, they can borrow against their investments to avoid selling them and paying income tax on gains.

Such strategies helped some of the country’s richest men — including Warren Buffett, Jeff Bezos, Michael Bloomberg and Elon Musk — pay little to no tax compared to their wealth in recent years, according to a ProPublica investigation.

“The very wealthy do not pay income taxes on all of their true income each year the way the rest of us do,” Steve Wamhoff, the director of federal tax policy at the Institute on Taxation and Economic Policy, wrote.

When the wealthiest families incur income taxes on capital gains, they pay a top 23.8% federal tax rate on the transaction, lower than the top 37% rate on income like wages.

President Joe Biden and congressional Democrats had initially aimed to change the rules around capital gains to make the tax code more equitable and raise revenue for their agenda, including investments for paid leave, education, health care and child care and to fight climate change.

There have been many proposals, none of which ended up in the most recent Build Back Better plan. Among other things, the measure would instead create a surtax on those with annual income of more than $10 million; however, because it’s tied to income, it wouldn’t touch the wealth created by unsold investments.

An earlier Biden plan, for example, would have taxed an asset’s appreciation upon its owner’s death. The plan aimed to keep the super-wealthy from continually passing financial assets to the next generation for little or no tax. (The first $2.5 million of gains for married couples were exempt.)

Some families may ultimately owe estate tax (once a married couple’s cumulative estate exceeds $23.4 million). Techniques like trusts can also help lower that tax bill.

Biden also called for the top capital gains tax rate to be the same as his top proposed rate on other income, at 39.6%.

The Senate also briefly entertained a “billionaires income tax,” proposed by Sen. Ron Wyden, D-Ore., chair of the Finance Committee. It would have taxed the investment gains of billionaires every year. (It would also apply to those with more than $100 million of income for three consecutive years.)

The concept is similar to a wealth tax posed by lawmakers like Sens. Elizabeth Warren, D-Mass., and Bernie Sanders, I-Vt.

“The proposals differ quite a lot,” William McBride, vice president of federal tax and economic policy at the Tax Foundation, said of the various Democratic plans. “No one’s determined the best way to do this.

“They are sort of experimental.”

While there seems to be ample revenue potential from such policies, levying taxes on the appreciated public stock of wealthy company founders could create a disincentive for entrepreneurship, McBride said. However, that effect isn’t well quantified and tax rates may not play a major role in such a decision, he added.

Taxing unrealized capital gains could emerge again in Build Back Better legislative negotiations, which will extend into 2022. Even if lawmakers scrap the policy for now, it may emerge in the future, McBride said.