Washington State’s new capital gain tax has passed through state congress and been signed into law. Like the new Long-Term Care Payroll Tax, it’s not clear if this tax will survive legal challenge because the state constitution prohibits income tax. Proponents call it an excise tax on sale of assets, while opponents say it’s clearly an income tax.
Here’s what you need to know and what you can do to prepare.
What is the tax rate?
A 7% flat tax would be charged on state residents’ long-term capital gain after exemptions and deductions.
What is being taxed?
The tax applies to long-term capital gain only – gain on assets held longer than 1 year. Short-term gain, ordinary income, interest, and qualified dividends are not subject to the tax.
When does it start?
The tax begins on January 1, 2022 – the tax will not apply to capital gains realized in 2021.
Who pays the tax?
All Washington State residents will be subject to the tax. Those outside the state are not generally subject to the tax unless selling tangible personal property inside the state.
Corporations and other entities are not subject to the tax, but owners receiving a capital gain allocation from pass through entities like S Corps, LLCs, and Partnerships would personally pay tax on their portion of the gain.
What deductions apply?
The first $250,000 in long-term gain is exempt from tax for each individual and married couple. Married couples share a single deduction – each spouse’s deduction is $125,000.
An additional charitable deduction is available of up to $100,000 if total charitable contributions exceed $250,000. So, to get the full $100,000 deduction, a taxpayer would need to make total charitable contributions of $350,000.
What assets are exempt from the tax?
In addition to the deductions detailed above, gain on some assets is exempt from the tax altogether, including:
- Real estate and gains from privately held entities directly attributable to real estate
- Retirement accounts
- Certain breeding livestock
- Certain timber, timberland, and agricultural land
- Commercial fishing privileges
- Sale of “substantially all” (at least 90%) or transfer of substantially all of an individual’s interest in a qualified family-owned small businesses with less than $10,000,000 annual revenue
What should I do to avoid it?
As always, we start with your goals. Are you selling assets to support your living expenses? Are you trying to provide for family and loved ones? Are you giving to causes you care about?
Depending on your goal, consider these strategies to reduce the tax impact on your planning.
Support your living expenses
- Accelerate capital gains in 2021 – Consider taking gains this year before the tax kicks in rather than waiting until future years.
- Increase portfolio income to limit capital gains – If you’re selling stock each year to provide income, look instead for opportunities to allocate toward higher income-producing stocks this year, allowing you to live more on income and less on sale proceeds.
- Leave Washington State – It sounds extreme, but if you’ve exhausted all other options, consider establishing residency in a lower tax state, as we discuss in Should I Leave Washington State to Avoid the Estate Tax?.
Provide for family and loved ones
- Gift appreciated assets to lower-income family members – Rather than selling assets and giving proceeds to loved ones in need, gift appreciated stock or other assets directly to them. When they sell, they’ll be able to use their own $250,000 deduction before any tax applies.
Give to causes you care about
- Gift appreciated assets to a Donor Advised Fund. Asset sales inside a Donor Advised Fund are tax-free and you can give proceeds to almost any qualified charity, minimizing tax and increasing the impact of your gift.
- Make larger contributions to a Charitable Remainder Trust. This strategy can help reduce or eliminate taxes on sales of highly appreciated assets, provide income for you today, and give to charity at your death.
If the new Washington State capital gain tax survives legal challenge, you may not be able to entirely avoid the tax as a state resident, but with a carefully designed comprehensive plan, you can certainly make moves to minimize the tax and stretch your hard-earned dollar further!
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