Selling Stock At Year-End To Harvest Losses? Don't Get Tangled In The 'Wash Sale' Rule

“Harvesting” capital losses to offset capital gains on your tax return is a popular year-end strategy. But watch out for wash sales, which can tangle up your tax planning. This article explains what you need to know to avoid this tax trap.

Tax-Loss Harvesting And Wash Sales

In brief, the tax rules let you net capital losses against capital gains on Schedule D of your Form 1040 tax return. Any unused capital losses you can then net against up to $3,000 of ordinary income. Lastly, you can then carry forward any remaining losses to the next tax year. If you think stocks will go up in 2023, you may think it makes tax sense to sell loss-makers now, before the end of 2022, and repurchase those stocks soon afterward to keep your investment in them.

For example, after the stock market declines of 2022, you may now hold securities—whether stocks, ETFs, or mutual funds—that would generate capital losses if sold. Those losses could then be used to offset capital gains and a limited amount of ordinary income.

Here’s where that crafty tax plan runs into trouble. A sale of stock at a loss coupled with the repurchase of the same stock within 30 calendar days after the sale will trigger the wash-sale rules, disallowing, for now, the capital loss. Below are key facts to understand about these rules.

Seven Points To Know About Wash Sales

1. The disallowed loss is not “lost” (with one big exception: see #4 below). Instead, the loss you’re not able to claim on your upcoming Form 1040 tax return is added to the replacement stock’s basis and holding period. If you purchase fewer shares than you sold, the wash-sale treatment applies only to that number of shares (i.e. not the entire number of shares initially sold).

2. While the timeframe for wash sales is often presented as a 30-day window, it’s actually a 61-day window covering the 30 days before and after your sale, regardless of whether that period spans two years. Buying in early January the same stock you sold at a loss at the end of December would definitely be deemed a wash sale.

3. The rules are triggered when you buy “substantially identical securities” before or after the loss. Let’s say you’re selling at a loss the stock in the company you work for but believe strongly that its price will rebound. You’re stuck with the wash-sale time limits once you sell it, and you also need to follow the insider-trading rules even before you do. You could instead buy the stock of another company in the same industry or in a mutual fund or ETF tracking that industry.

4. The wash-sale rules do not directly apply when the sale and purchase both occur in your 401(k) or IRA, as capital gains and losses are not tracked in those accounts. However, after the sale in your retail brokerage account, you cannot outfox the IRS by instead purchasing the same security in your IRA or 401(k). IRS Revenue Ruling 2008-5 goes even further: it prevents you from adding this loss to the basis of the shares purchased in your IRA. That would permanently eliminate the capital loss disallowed in the year of sale.

5. Trades involving listed options, employee stock option exercises, and shares bought through employee stock purchase plans (ESPP) or dividend reinvestment plans (DRIPs) can cause a wash sale when they occur within 30 days after you sell the stock at a loss. The treatment for incentive stock options (ISOs) is more draconian still, as a wash-sale loss is triggered even when you sell the ISO stock at a price higher than the exercise price but lower than the market price on the date of exercise. For restricted stock or restricted stock units, the grant itself or its vesting may also trigger the wash-sale rules when you have sold stock at a loss, as explained by an FAQ at myStockOptions.com.

6. Your brokerage firm will track and report wash sales by account. It may not do this across different accounts that you (and your spouse) have at the firm and at other brokers. Therefore, you and/or your tax-return preparer must consider trading activity in securities across all the accounts you have.

7. Form 1099-B, which you receive from your broker in time for tax season (usually by Feb. 15), reports all of your stock sales from the prior year. It shows (in Box 1g) the amount of any nondeductible loss stemming from a wash sale involving covered securities (at least for those in the same account). Note that many brokerage firms reformat Form 1099-B into their own substitute statement that has columns labeled the same as the boxes on the IRS form. You still need to report the wash sale on your tax return on Form 8949, even though the loss on those shares will not be immediately recognized, and adjust the tax basis on the replacement shares when you sell them.

More Tax Resources

See IRS Publication 550 for the IRS guidance on wash sales. It appears in the subsection “Capital Gains & Losses” of Chapter 4 (pages 56–57 in the version for 2021 tax returns).

When your tax planning (and your tax return) for 2022 involves income from company stock sales and/or equity compensation, such as stock options, restricted stock units, or ESPPs, explore the Tax Center at myStockOptions.com and consult a qualified tax or financial advisor. We have articles, FAQs, videos, and annotated IRS forms that demystify the complex federal tax rules. On December 1, myStockOptions.com is also holding a webinar on year-end and year-start financial planning and tax strategies for equity comp (see section below).

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WEBINAR: Year-End 2022 Financial & Tax Planning For Equity Comp

Thursday, December 1, 2022
2:00pm to 3:40pm ET (11:00am to 12:40pm PT)
2.0 CE credits for CFP, CPE, EA, CPWA/CIMA, and CEP

In this lively webinar, boost your knowledge of year-end and year-start strategies for stock options, restricted stock/RSUs, ESPPs, and company stock holdings to help you make smarter decisions and prevent costly mistakes. Volatile markets and economic uncertainty make the need for effective guidance even more important, as this webinar will cover.

In 100 minutes, the webinar features insights from a panel of three leading financial and tax advisors, including real-world case studies, to provide practical expertise on equity comp in both public and private companies. Minimize taxes and build wealth with their know-how on the essentials of year-end and year-start planning.

Time/date conflict? No problem. All registered attendees get unlimited streaming access to the webinar recording for their personal viewing, along with the detailed presentation slide deck and handouts.

Agenda and panelist details are available at the webinar registration page.

"The knowledge I gained from myStockOptions, both as a premium member and from your webinars, has made me stand out at work." —Vincent Leonardo (EA), Tax Analyst, Intuit

4 Ways Biden's Tax Proposals Could Affect Stock Comp Financial Planning

Millions of employees in the United States have stock compensation and/or holdings of their companies' shares. Many of them may be depending on these for major financial goals, such as a buying a house, saving for retirement, or funding children's college tuition. Could President Biden’s proposed tax changes impact their gains and their financial planning?

The short answer: yes, they very well could, depending on your income. While the future of the proposals remains highly uncertain, some of the proposed tax increases, such as a major hike in the top rate of capital gains tax, may require you to take action well before any new tax legislation is adopted.

The proposed tax provisions to follow are in the American Jobs Plan and the American Families Plan. The US Treasury’s General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals, known informally as the “Green Book,” provides a summary and rationale of the tax changes.

Don’t have time to read Congressional legislation or a tome written by the US Treasury? No problem. At myStockOptions, we read that stuff so you don’t have to, along with related commentaries from law firms and other expert observers. Below is what to know about the potential impact of Biden’s tax proposals on stock compensation and company shares that you hold. For financial advisors, this provides an opportunity to reach out to clients about the possible changes and the impact on decisions involving stock options, restricted stock, ESPPs, and company stock holdings.

1. Top Tax Rate

Currently, the flat supplemental wage withholding rate, which applies to income such as stock compensation and cash bonuses, is 22% for yearly amounts up to $1 million and 37% for yearly amounts in excess of $1 million. That higher withholding rate is tied to the top tax bracket.

Under Biden’s plan, the highest ordinary tax bracket rate would go from 37% to 39.6% starting January 1, 2022 (see page 60 of the Green Book). That would therefore increase the higher rate of supplemental wage withholding to 39.6%. This rate would also apply to short-term capital gains for anyone in the top tax bracket.

ACTION STEPS: When you decide to exercise nonqualified stock options (NQSOs), you control when you will realize the taxable income at exercise, including federal tax. If you’re in the top tax bracket or will be from your option exercise, analyze whether for tax reasons it makes sense to exercise the options in 2021 instead of in 2022, when that bracket rate may be higher.

While most financial advisors would not suggest you make stock option exercise decisions solely for a 2.6% tax savings, this potential tax hike is worth evaluating as a factor for options close to expiration. For options not close to expiration, remember that NQSOs offer substantial leverage and upside, all of which ends as soon as you exercise the options (see the prior article in this blog).

Private companies with a recent or upcoming initial public offering (IPO) have a special concern. If your company has granted double-trigger-vesting restricted stock units (RSUs), in which typically the shares are not fully vested and delivered until six months after the IPO, the company may want to consider accelerating the share delivery into 2021 should the change to the top income-tax bracket be enacted. Accelerating that income into 2021 by delivering the shares this year (when the top rate is 37%) will save taxes for employees who have already met the requirements of both the time-based and the liquidity-event vesting conditions.

2. Capital Gains Tax Rate

Long-term capital gains, such as from company stock sales, currently have a top tax rate of 20% (plus the 3.8% Medicare surtax). Biden’s tax plan would raise the top rate on long-term capital gains and on qualified dividends to the highest rate of ordinary income tax for households with over $1 million in adjusted gross income ($500,000 for married filing separately).

The rate change would be retroactive to the date it was announced, considered to be April 28, 2021, when President Biden issued a Fact Sheet on the American Families Plan. The change for taxes for capital gains realized at death and with gifts, discussed below, would start January 1, 2022. (See pages 61–64 of the Green Book for more details on these capital gains proposals.)

Action Steps: With incentive stock options (ISOs) taxation, when you hold the shares more than two years from grant and one year from exercise, the full gain at sale over the exercise price is capital gain. While the tax treatment for NQSOs is fixed at exercise, for ISOs when you sell the stock without meeting the holding periods the tax treatment changes to essentially follow the ordinary income rates. Anyone with annual income of more than  $1 million will want to evaluate whether to risk holding ISO shares for the long-term capital gains rate when that rate would actually, under Biden’s plan, match their ordinary income rate.

Similar thinking applies to the decision with restricted stock about whether to make a Section 83(b) election to be taxed at grant instead of vesting. One big advantage of the election is to get an early start on the holding period for long-term capital gains. But under the proposed change, the tax rates on long-term and short-term capital gains for people in the top tax bracket may become the same anyway.

Details Murky On Proposed Change And Its Potential Impact

According to some experts, it remains unclear whether this higher capital gains rate would apply to all capital gains income or to only some portion of it (see Tax Reform In The American Families Plan from the law firm Morgan Lewis). Among the many other issues are how this change would impact the 0% rate on qualified small business stock (QSBS). The potential impact for individuals with stock by this proposed change, including the range of open issues and when to recognize capital gains income, is addressed by articles from Tech Crunch (Startup Employees Should Pay Attention To Biden’s Capital Gains Tax Plans), McDermott Will & Emery (What a Capital Gains Rate Hike Could Mean), and Morningstar (Capital Gains Tax Proposal a Wake-Up Call to Assess Concentrated Holdings).

The law firm Proskauer Rose predicts that if the capital gains rate increases, affected taxpayers will “defer sales of appreciated property and to use cashless collars and prepaid forward contracts to reduce economic exposure, and to monetize, liquid appreciated positions” (see Treasury’s Green Book Provides Details on the Biden Administration’s Tax Plan).

3. Capital Gains Realized Upon Death Or At Gifting Of Stock

Biden’s tax plan would dramatically change the capital gains treatment via gifting or upon death for transfers of appreciated property, such as company stock. For example, the ability to eliminate capital gains at death by a step-up in the basis on the shares, which allows heirs to then pay tax only on the appreciation after death, would no longer apply to gains over $1 million per person ($2 million per couple).

Alert: This does not mean that the basis for the remaining stock over these amounts is just carried forward to the person(s) inheriting it or the beneficiary, as has been misreported in some sources. Death itself triggers the recognition of capital gains tax on these amounts as if the stock was sold!

Similarly, any gifts made over these amounts would be taxable at that time to the gifter. Currently the receiver just carries forward the basis, and the giver would owe gift tax only if they did not have any of their lifetime gift/estate exemption amount remaining. Exceptions would apply, such as with transfers to a spouse, a charity, or heirs of small businesses and farms that continue to run those businesses. Donations of highly appreciated stock to charities would still avoid the capital gains tax, making it an even more popular strategy.

The Biden administration’s proposals so far do not yet include lowering the estate tax exemption from the current $11.7 million per person ($23.4 million for married couples), which was discussed during the campaign and may be forthcoming. However, that amount does automatically go down to $5.49 million per person (adjusted for inflation) at the start of 2026, when the provision sunsets at the end of 2025 under the Tax Cuts & Jobs Act (TCJA).

4. Beefed-Up Enforcement

The proposed legislation provides funding to “revitalize enforcement to make the wealthy pay what they owe” in an effort to shrink the tax gap, according to the Fact Sheet on the American Families Plan. This means with certainty an increase in audits of companies, executives, and others who are wealthy because of their stock compensation or founders’ stock. The audit rates on those making over $1 million per year, which fell by 80% between 2011 and 2018, will increase substantially. Financial institutions would be required to report information on account flows so that earnings from investments, such as from stock compensation and company stock holdings, are subject to broader IRS reporting.

Likelihood Of Tax-Law Changes

Whether any of these proposals will get adopted in their current form, and with the proposed effective dates, remains uncertain. Doubts about what will happen are raised by experts quoted in articles from Investment News (Political Reality Seen Curbing Biden’s Tax Plan) and Politico (Tax The Rich? Executives Predict Biden’s Big Plans Will Flop). The lobbyist and business group leaders quoted in the Politico article seem confident that they will pressure moderate Democrats in the House and Senate to “kill almost all of these tax hikes.”

A reminder of what tax ideas have not yet been proposed by Biden, such as taxing stock options at vesting, appears in a commentary from the law firm Brownstein Hyatt Farber Schreck (Will Biden’s American Families Plan Take Aim At Executive Compensation?). That proposal had been part of the initial draft of the TCJA, the tax-reform law enacted at the end of 2017.

myStockOptions Webinar Channel

See the myStockOptions webinar channel to register for our upcoming webinars and purchase our past webinars on demand in streaming format. On-demand webinars include:

Restricted Stock & RSU Financial Planning: Advanced Bootcamp (100 mins). This lively webinar features insights from a panel of three leading financial advisors, including case studies, to provide practical info, guidance, and expertise for restricted stock/RSUs in both public and private companies. 2.0 CE credits for CFP, CPWA, CIMA, and CEP.

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Stock Compensation Bootcamp For Financial Advisors (100 mins). Whether you are new to stock comp or want to sharpen your knowledge, our bootcamp webinar provides practical information and insights to maximize success. 2.0 CE credits for CFP, CPWA, CIMA, and CEP.

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Stock Sales: 7 Topics To Understand When You Sell Shares To Raise Cash Quickly

These are challenging times for everyone. For reasons beyond your control, you may find yourself in a position where you suddenly need to come up with cash to meet living expenses or other urgent financial demands. The proceeds from selling shares of your company's stock, whether acquired via equity compensation or open-market purchases, can be a source of these needed funds.

However, when making stock sales you must always proceed with caution. Before you sell your company shares, review this checklist of topics to understand on tax, company, brokerage firm, and SEC rules.

1. Understand Capital Gains Tax Basics To Generate Capital Losses

When you sell shares, assuming they’re not in a retirement plan account (e.g. a 401(k) or IRA), you generate a capital gain or a capital loss. The calculation is the amount of the sale proceeds over or under your cost basis, i.e. what the shares cost to acquire plus any W-2 income you recognized for the equity compensation. For stock held over one year after a stock option exercise, vesting of restricted stock units (RSUs), or a purchase in an employee stock purchase plan (ESPP), the gain or loss is long-term, meaning a lower tax rate applies. Shares held for less than one year are taxed at short-term capital gains rates, similar to that of your salary income.

If you have a choice of company shares to sell, you want to first sell stock that generates a capital loss which you can harvest against capital gains. What that means is that you can net the capital losses against any current capital gains, with unused losses deducted against $3,000 of your ordinary income. The remainder of the loss is carried forward to future tax years. When you do not have shares to sell at a loss, your next choice is stock that has the smallest long-term capital gain.

2. Clearly Identify The Lot Of Shares You Want To Sell

When you hold company shares that you’ve received at various times, such as yearly RSU vesting or twice-yearly ESPP purchases, you want to identify at the time of sale which share lot is being sold. The default rule is “first in, first out” (FIFO), but you can choose. Any shares you received at a recent market high are the ones you want to sell for a loss. Make sure you get clarification on how to indicate specific lots to sell through your brokerage firm’s website.

3. Watch Out For Wash Sales

A “wash sale” is deemed to occur if you sell company stock at a loss but you have also separately purchased the same stock within 30 days before or after the sale. That triggers the special rules for wash sales. Under those rules, the loss and holding period are carried over to the replacement shares.

According to most experts, any restricted stock or RSU vesting 30 days before or after the loss sale would be considered a wash sale and trigger the related rules. Similar treatment applies to an option exercise, ESPP purchase, or dividend reinvestment plan on company stock. Those are all considered purchases.

4. Job Loss? Carefully Follow Your Company’s Post-Termination Stock Option Exercise Rules

You may intend to exercise stock options and immediately sell the shares to generate needed cash.  However, if you lose your job, vesting usually stops on all types of stock compensation. In that case, you must quickly exercise any outstanding vested stock options, typically within 90 days or less of your employment termination. As explained in the section Job Events at myStockOptions.com, if you do not exercise vested in-the-money stock options in time you will forfeit their value.

Alert: Check your stock grant agreement and your stock plan for the rules and exercise deadlines that apply to each option grant upon job loss. If anything is unclear, ask your company’s stock plan administrator.

5. Know Your Company’s Rules For ESPP Contributions

In an employee stock purchase plan, you can usually withdraw any accumulated funds that are waiting for the next purchase date. You need to check your company’s ESPP rules for how you do this. While an ESPP with a lookback and a 15% purchase discount can be an attractive investment in down markets, withdrawn ESPP funds can be another source of emergency funds. Furthermore, you can reduce or stop future ESPP contributions from your salary.

6. Be Mindful Of Holding Periods For ESPPs And ISOs

With stock from a purchase in a tax-qualified ESPP or an exercise of incentive stock options (ISOs), holding the shares for more than one year from enrollment/grant or two years from purchase/exercise gives you special tax treatment on the sale. Remember that the tax treatment is affected by selling those shares early. That’s called a disqualifying disposition, with different ramifications for ESPPs and ISOs. This is another reason to carefully choose and specify the lot of shares you want to sell, as explained in #2 above.

7. Beware Of Insider Trading

Understand that sometimes stock trades can actually get you into trouble. If you buy or sell shares of your company’s stock while you know material nonpublic information (MNPI), you are committing insider trading, which is illegal. Material nonpublic information refers to company secrets that, when made public, would move the company’s stock price up or down. This prohibition against trading on confidential inside information applies even if you are no longer employed by the company.

The type of information that could be considered MNPI is not always clear. However, common sense is a good guide. MNPI is any confidential company information that, once publicly known, could affect your company’s stock price in a positive or negative way. Examples include undisclosed financial results, a merger or acquisition that has not been announced, or a new product that has not been publicized. This prohibition also applies to confidential information you learn in your job about a corporate client, supplier, or other organization that you work with.

Alert: The SEC and the US Department of Justice are watching closely for insider trading related to the stock-market impacts of the COVID-19 pandemic and expect to pursue enforcement activities.

In addition to the securities laws about insider trading, your company may also have its own stock-trading pre-clearance rules, along with mandated blackout periods and window periods for stock trading.

Capital Gains On Stock Sales: 6 Ways Under The Tax Code To Defer Or Pay No Capital Gains Tax

Sooner or later, assuming the company's stock price rises, employees who acquire shares from equity compensation must sell them to realize the financial benefits of their grants. These could be shares that appreciated substantially from a stock option exercise, restricted stock/RSU vesting, or ESPP purchase long ago. They could be founder's stock or shares from equity compensation in a startup that later turned into a hot IPO company.

While most securities held over one year qualify for the favorable rate on long-term capital gains, the total capital gains tax can still be significant. However, the US tax code provides a few perfectly legal ways, depending on your income, financial goals, and even life expectancy, to defer or pay no capital gains tax, maximizing the benefits of your grants and letting you put away more in your piggy bank.

Most of these ways to defer or eliminate capital gains tax are considered tax expenditures: tax-code provisions created to encourage certain activities or benefit certain categories of taxpayers. Below we explain six of these provisions (ideally considered only with advice from a financial or tax planner on your personal situation).

1. The 10%–15% Tax Bracket

For people in the 10% or 12% income tax bracket, the long-term capital gains rate is 0%. Under the Tax Cuts & Jobs Act, which took effect in 2018, eligibility for the 0% capital gains rate is not a perfect match with the income ceiling for the 12% income tax rate. The income thresholds for the 0% rate are indexed for inflation:

• in 2019, $39,375 (single filers) and $78,750 (joint filers)
• in 2020, $40,000 (single filers) and $80,000 (joint filers)

Before you believe you quality for this special 0% capital gains rates, or think you can shuffle your stock to someone else in a lower tax bracket who can sell to get the 0% rate, you want to be sure you don’t trip over the tax rules. For example, the net gains from your stock sale count against the income limit. Should you decide this is a good year to convert a traditional IRA to a Roth IRA, that income counts, too. The “kiddie” tax is triggered should the gifted stock be sold by a child under the age of 19 (for full-time students, under the age of 24).

2. Using Tax Losses

Capital losses of any size can be used to offset capital gains on your tax return to determine your net gain or loss for tax purposes. This could result in no capital gains at all to tax. Called tax-loss harvesting, this is a popular strategy. While only $3,000 of net capital losses can be deducted in any one year against ordinary income on your tax return, the remaining balance can be carried over to future years indefinitely. When you follow this strategy in selling losers, you want to be careful to avoid the rules about “wash sales” should you plan to soon repurchase the same stock. (See our blog commentary on this: Year-End Stock Sale To Harvest Capital Losses: Beware Wash Sales!)

3. Stock Donations

Planning to make a big donation to a qualifying charity? Instead of selling the appreciated stock, paying the capital gains tax, and then donating the cash proceeds, just donate the stock directly. That avoids the capital gains tax completely. Plus, it generates for you a bigger tax deduction for the full market value of donated shares held more than one year, and it results in a larger donation.

With donations that put you over the yearly standard deduction amount, the stock donation also reduces your overall taxable income. You could donate the shares to a donor-advised fund if you’re uncertain about your philanthropic goals for all the stock. If you’re fortunate enough to be wealthy, consider a charitable remainder trust or private foundation.

4. Qualified Small Business Stock

Private company shares held for at least five years that are considered qualified small-business stock (QSB) may be eligible for an income exclusion of up to $10 million or 10 times their cost basis. This is separate from the approach of rolling over your capital gains by reinvesting them within 60 days of sale in another startup. For the stock to qualify, the company must not have gross assets valued at over $50 million when it issued you the shares. For more details on both the rollover deferral and the 100% gain exclusion strategies for QSB sales, see a related article on myStockOptions.com.

5. Qualified Opportunity Zones

The Tax Cuts and Jobs Act created “Opportunity Zones” to encourage investment in low-income distressed communities that need funding and development. This is the newest way to defer and potentially pay no capital gains tax. By investing unrealized capital gains within 180 days of a stock sale into an Opportunity Fund (the investment vehicle for Opportunity Zones) and holding it for at least 10 years, you have no capital gains on the profit from the fund investment.

For realized but untaxed capital gains (short- or long-term) from the stock sale:

• The tax on those capital gains is deferred until the end of 2026 or earlier should you sell the investment.
• For capital gains placed in Opportunity Funds for at least 5 years until the end of 2026, your basis on the original stock investment increases by 10%. The basis increase goes to 15% if invested at least 7 years until that date (this means you must make the investment by December 31, 2019, to potentially get the 15% basis bump).

The new tax incentive is complex and controversial. It faces potential legislative changes. Unresolved issues also remain on some aspects, as shown by FAQs and ongoing guidance from the IRS.

6. Dying With Appreciated Stock

While this may seem like an extreme planning technique, hear us out. The standard calculation for capital gains in your retail brokerage account (not securities in a 401(k), IRA, or other tax-qualified retirement plan) after commissions and fees is:

capital gains = sale proceeds – cost basis [purchase price of stock]

Should you sell the stock during your lifetime, the net proceeds in this equation are your capital gains (or losses). Should you gift the stock, the cost basis carries over to the new owner.

Yet when you die before selling or gifting, this cost basis in most situations is “stepped up” to the fair market value on the date of death. The stock escapes the capital gains tax on the price increase during your lifetime, regardless of the size of your estate. (Any potential capital loss deduction also goes away should the stock price have dropped since purchase.) Thus, no taxable gain is recognized when the inherited shares get sold at no higher than the death-date price.

All the 2020 Democratic presidential candidates seem to be calling for the elimination of this provision. This tax rule, which was not changed when the estate tax income exemption amount increased, is viewed as a tax loophole for super-wealthy people who create sophisticated trusts and estate-planning strategies. However, this tax treatment at death to step up the basis is available for everyone and does eliminate (or reduce) the taxes your heirs and beneficiaries pay.

Capital Gains Tax: What Democratic Presidential Candidates Are Saying And What Tax Changes Might Look Like

At myStockOptions, we are listening for policy hints from the Democratic presidential candidates that may affect equity compensation if Democrats regain control of the White House and Congress in 2020. This includes the potential for changes in the long-term capital gains tax, a stated goal for several of the Democratic candidates.

Capital Gains Tax: A Review

Capital gains on asset sales are often still associated with the wealthy and not the middle class. However, anyone who sells a house is subject to the tax rules of capital gains and losses. Anyone who sells stock, ETF holdings, or mutual funds in non-retirement brokerage accounts incurs a capital gain or loss. Nowadays, that's not just the wealthy. For example, an employee incurs a capital gain or loss when selling company shares acquired from stock option exercises, restricted stock/RSU vesting, or ESPP purchases, even if the number of shares is small. Capital gains tax has therefore become a commonplace feature of individual taxation for many US citizens, not just the wealthy minority.

While the Tax Cuts and Jobs Act made significant changes in the rates and brackets of income tax in 2018, it did not modify the long-term capital gains tax rates (15% and 20%) that apply to gains from shares acquired from stock compensation and held for at least one year. Those rates have been in place for many years.

However, if Democrats win the presidency and a workable majority in Congress, we should expect changes in the long-term capital gains tax as part of Democrat efforts to increase federal revenue and reduce income inequality. This is clear from statements made by Democratic candidates, the tax-policy positions they have issued, and research from other sources (see commentaries from Politico, The Hill, and Kiplinger). If your decisions at year-end on whether to hold or sell investments tend to be tax-driven, you could be very busy in December 2020.

Democratic Presidential Candidates: What They Are Saying

Below is a sample of specific policies for capital gains tax that Democratic presidential candidates have proposed:

• taxing capital gains income the same as compensation income (Cory Booker, Amy Klobuchar, and others)
• increasing the capital tax rates for incomes over $1 million (Joe Biden)
• eliminating the lower capital gains rates for those with household income above $250,000 (Bernie Sanders)
• a wealth tax for the richest top 0.1% that in essence taxes the gains on assets before any sale proceeds are realized (Elizabeth Warren)
• ending the step-up at death in the basis of inherited assets

Meanwhile, as we discussed in a recent blog commentary, the Trump White House is pulling in the opposite direction on capital gains. It is seriously considering a presidential executive order which would index the capital gains cost basis for inflation. That would effectively result in a tax cut—controversially, without the approval of Congress. It seems that the future of capital gains taxation could take a very different path if the Democrats do not regain the White House in 2020.

Varying Approaches To Capital Gains Taxation

While most of the Democratic candidates appear to support eliminating the different tax rates that apply to long-term capital gains compared to compensation income, those policies might not mean all the gain would be taxable. There could be an income-exemption amount for a certain percentage of gains. No candidate has mentioned this approach, which was actually part of the US tax code before the Tax Reform Act of 1986. Tax exemptions on a certain percentage of capital gains are applied by several other countries now. For example, in Canada, only 50% of capital gain is included in income, and it's then taxed at the individual's income tax rate.

Interestingly, tax policies in countries around the world embrace the rationale that capital gains should be taxed differently than employment income. For example, that is the case in Denmark, Sweden, and Germany, countries that have more progressive social-welfare programs and less income inequality than the United States. (You can sample other tax treatments of capital gains and equity compensation around the world in the Global Tax Guide at myStockOptions.com.)