How to Reduce Capital Gain Taxes Under Biden’s 2021 Proposal Using an Installment Sale Under Current Internal Revenue Code Section 453.
By Paul J. Lesti, CSSC, RSP, MSSC
There are reports that President Biden’s 2021 American Families Plan proposes to increase the marginal tax rate for capital gains to 39.6% for those earning more than $1 million. This article will outline existing relevant taxes, exemptions and fees, and describes a solution using current tax laws. Please note that this increased capital gain rate proposal is not a law and will likely change before being finalized.
Federal Capital Gains. Federal capital gains are currently taxed at 15% for single taxpayers earning over $40,000 in Modified Adjusted Gross Income (MAGI), married taxpayers filing jointly earning over $80,000 and for heads of households earning over $53,600. The marginal capital gain tax rate rises to 20% for single taxpayers earning over $441,450, married taxpayers filing jointly earning over $496,600 and for heads of households earning over $469,050. https://irs.gov/taxtopics/tc409
Net Investment Income Tax. Taxpayers are subject to a 3.8% Net Investment Income Tax, NIIT, under Internal Revenue Code Section 1411. This is sometimes called the Affordable Care Act, ACA tax, or Obamacare tax. This tax is due on certain net investment income of individuals, estates and trusts. This 3.8% tax is imposed if Net Investment Income and MAGI is greater than certain levels: $250,000 for those who are married filing jointly or a qualifying widow(er); $125,000 for those who are married and file separately; and $200,000 for single taxpayers or a head of household. This tax, however, will not apply to any amount of gain that is excluded from gross income for regular income tax purposes. For example, See IRC section 121 under the Exemption for Principal Residence paragraph below. https://irs.gov/taxtopics/tc559.
State Capital Gains. In some states there is no tax preference for capital gains. This may result in substantial taxes in some cases. For example, in California a 12.3% marginal tax rate is owed on capital gains for taxpayers whose taxable income, including capital gains, is greater than the following: $599,012 for single or married filing separately; $1,198,024 for married filing jointly or a qualifying widow(er); and $814,658 for a head of household. California tax information 2020
Alternative Minimum Tax. Another potential tax is the Alternative Minimum tax or AMT under IRC section 55. A taxpayer may owe AMT if certain types of deductions, exclusions, and credits are used and if one’s alternate minimum taxable income (AMTI) from Form 6251, line 4 is greater than the following exemptions: $113,400 if married filing jointly or a qualifying widow(er); $72,900 if single or head of household; and $56,700 if married filing separately. There are certain exemption phase-out thresholds. These are $518,400 in AMTI for single, head of households and married filing separately and $1,036,800 for those who are married filing jointly or qualifying widows(ers).
Additional Medicare Premiums. Some taxpayers are subject to Medicare premium increases. The 2020 standard Medicare Part B monthly premium is $144.60. The monthly premium amount for Part B and the Prescription drug coverage increases with MAGI. Medicare calls this additional premium the “income-related monthly adjustment amount”. For individuals with MAGI over $500,000 the Part B monthly premium increases to $347.00 and the prescription drug coverage monthly premium increases to $76.40. This amounts to $5,080.00 annually. This same $5,080.00 increase applies to those who are married filing jointly with MAGI above $750,000. For those who are married and filing separately the $5,080.00 annual premium applies if MAGI is greater than $413,000. There are other iterations at lower income levels.
Exemption for Principal Residence. Taxpayers don’t have to pay tax on the entire price increase of their principal residence. Internal Revenue Code Section 121 exempts the first $500,000 from gross income on the gain of a principal residence for married couples filing jointly and certain surviving spouses. This exemption drops to $250,000 for single filers and others who qualify. There are also residency, usage and other requirements. This exemption may be substantial for those whose homes did not appreciate over these amounts. However, this exemption may not be as advantageous when residences have appreciated significantly above $250,000 or $500,000.
Biden’s 2021 Capital Gain Proposal. Federal capital gain taxes are proposed to increase to 39.6% for those earning more than $1 million. This will affect approximately 0.3% of U.S. taxpayers or about 500,000 households according to Brian Deese of the National Economic Council, per media reports. This means that a California couple filing jointly with $2.2 million of capital gain will pay a marginal tax rate of approximately 55.70%. This includes 39.6% for capital gains, 12.3% for California taxes, and 3.8% for NIIT. This 55.7% rate does not include any AMT or any increased Medicare Premiums. Please note that marginal tax rates are higher than tax rates actually paid.
Most taxpayers do not normally have over $2.2 million in income and capital gains. If they do it is probably when a home is sold, which is not a routine event. Homeowners who had the good fortune to have purchased a home many years ago in a highly appreciating real estate market may be subject to this 55.7% marginal tax rate. For example, this may occur if a home was purchased many years ago for $300,000 and it now sells for $2.2 million in cash. Such property appreciation may occur in certain areas of California, New York and other regions of the U.S.
Business, commercial property owners and private stock owners who sell their highly appreciated assets will have similar tax exposure and more. This is because these taxpayers do not enjoy the $500,000 or $250,000 exemption from capital gains enjoyed by certain homeowners.
Solution to Reduce Capital Gains. An Installment Sale under Internal Revenue Code 453 is a proven solution to defer capital gains into the future. The goal is to have the capital gain income paid into future years to fall below the thresholds for the highest existing and proposed marginal tax rates, or to minimize exposure to these rates.
Gains on single family homes, commercial real estate, a business and private stock may be deferred. Publically traded stocks and securities that are on an established securities market or otherwise, are not eligible to use this method.
An Installment Sale to defer capital gains has been useful for taxpayers under current laws, especially in states with high marginal tax rates. It will become even more valuable even if capital gain rates increase only modestly over current rates.
An Installment Sale can provide assured future income, as the seller receives payments from a Metropolitan Tower Life Insurance Company annuity. MetTower is rated A+ by A.M. Best. These payments are paid even if the buyer runs into financial difficulties. See Installment Sale Information for additional resources.
Paul J. Lesti, CSSC, RSP, MSSC
© Paul J. Lesti. 2021 All rights reserved. This is not tax or legal advice.