Proposed Changes to Capital Gains Tax Could Be a Big Boost to Giving

The American Families Plan proposed by the Biden Administration includes a long list of initiatives aimed at expanding government support of children and families. It would cover much of the cost of these initiatives through a series of tax changes that include a major overhaul in the tax treatment of capital gains. It is far from certain that these tax changes will become law, but it is worthwhile to examine how they might affect the behavior of your donors if they did.

Capital Gains Tax Today

Long-term capital gains, the appreciation of an asset that the owner has held for more than a year, is taxed at a top federal tax rate of 20% when the asset is sold by the owner. In 2021, the 20% rate applies to single filers with taxable income over $445,850 and married taxpayers filing jointly with taxable income over $501,600. The rate is 15% for most taxpayers below these thresholds.

When a donor gives long-term gain property to charity, the donor is allowed to deduct the current value of the property from taxable income and does not have to pay tax on the capital gain. This double tax savings provides a strong incentive for donors to give highly appreciated assets, such as stock, to their favorite charities rather than cash.

At death, appreciated assets passed to heirs through the deceased’s estate receive a “step-up” in basis. This means that the cost basis of these assets in the hands of the heirs is reset to match their value on the date of the deceased’s death. If the heirs were to sell the assets that day, they would owe no capital gains tax, no matter how little the deceased paid for the assets originally. In addition, the current federal estate tax exemption of $11.7 million per individual ($23.4 million per couple) eliminates the estate tax for 99.9% of estates. The combination of the step-up in basis and very high federal estate tax exemption means that for 99.9% of estates, the appreciation in assets passed through estates is never taxed. It also means that for all but 0.1% of estates, there is no federal tax incentive to give appreciated property to charity through the estate.

Proposed Capital Gains Taxes

The American Families Plan proposes a near-doubling of the tax rate on long-term capital gains from 20% to 39.6% for taxpayers with taxable income greater than $1 million. Believe it or not, there are over 500,000 U.S. taxpayers who make that much each year. For these donors, the tax benefits of giving long-term appreciated assets to charity will be greatly increased. Between income tax savings, and avoiding capital gains tax and the 3.8% Medicare surtax, they could save over $0.80 in taxes for every $1 of long-term appreciated assets they give to charity rather than sell themselves. The more highly appreciated the asset, the more they will save. Today, these same donors can save up to about $0.60 for every $1 of long-term appreciated assets they give to charity. Put another way, their cost of giving could be cut in half, from about $0.40 per $1 given to less than $0.20 per $1 given. Expect gifts of appreciated assets from these donors to increase substantially if this dramatic increase in their federal capital gains tax rate becomes law.

The American Families Plan proposes another change in the federal taxation of capital gains that would affect a far larger swath of donors than those with incomes greater than $1 million: elimination of the step-up in cost basis for inherited gains over $1 million ($2.5 million per couple when combined with existing real estate exemptions). As a result, instead of 0.1% of estates facing federal taxation, closer to 10% would. Estates would pay a 39.6% capital gains tax on gains passing to heirs that exceed the applicable exemption amount – 43.4% when you include the 3.8% Medicare surtax. If the estate were large enough to also owe federal estate tax, federal estate tax would also apply. Capital gains tax owed would be deductible from the estate taxable amount, so the total tax rate on the gains would be about 62%. Compare that to 40% today. Estate gifts of appreciated assets to charity would be exempt from federal taxation, creating a strong tax incentive for donors with more than $1 million of capital gain in their estate to transfer at least some of those appreciated assets to charity.

Example

A donor dies with an estate worth $8 million and a cost basis of $3 million. The estate includes no retirement assets.

  Current Law Proposed Law
Estate $8,000,000 $8,000,000
Cost Basis $3,000,000 $3,000,000
Capital Gain Exclusion $0 $1,000,000
Capital Gain $5,000,000 $4,000,000
Capital Gains Tax (43.4%) $0 $1,736,000
Estate Tax Exclusion $11,700,000 $11,700,000
Estate Tax $0 $0
Total Tax $0 $1,736,000

 

If the donor gives a $1 million asset with a $100,000 cost basis to charity rather than to heirs, under current law the donor’s estate would save no taxes. Under the proposed law, the donor’s estate would save $390,600 in taxes, a strong incentive to give the asset to charity.

  Current Law Proposed Law
Total Tax without Gift to Charity $0 $1,736,000
Capital Gain $4,100,000 $3,100,000
Capital Gains Tax (43.4%) $0 $1,345,400
Total Tax with Gift to Charity $0 $1,345,400
Tax Savings from Gift to Charity $0 $390,600

 

If the donor’s estate were worth $30 million instead, and therefore would owe a 40% federal estate tax on some of the estate, the tax savings from giving the $1 million asset to charity under current law would be $400,000. Under the proposed law, however, it would be $634,360. That is, the cost of giving the asset would decline from $0.60/dollar given to less than $0.37/dollar given. Donors with large estates would have an even stronger incentive to give appreciated assets to charity than donors with estates too small to owe federal estate tax.

Conclusion

Proposed changes to how capital gains are taxed during life, and at death, would create strong tax incentives for wealthy donors to give long-term appreciated assets to charity throughout their lives and through their estates. Time will tell, however, whether a dramatic increase in the top federal capital gains tax rate or a repeal of the step-up in cost basis at death actually becomes law. The negotiation process in Congress over these and other tax proposals is likely to be lengthy and heated. The end result is anyone’s guess, but some sort of increase in the federal taxation of capital gains is a real possibility. Should that occur, charities should be able to attract more appreciated property gifts as a result.