President Biden’s campaign promise never to raise taxes on those making $400,000 or less annually will inevitably conflict with his proposal to tax unrealized capital gains at death.
My TPC colleague Rob McClelland and I estimate Biden’s new capital gains tax could exempt about 98 percent of decedents who made $400,000 or less, but about 2 percent may face a tax increase. In other words, Biden would come very close to meeting his pledge, but a relative handful of lower-income decedents may pay higher taxes at death. And even that small number may add to the political challenges Biden faces as he tries to convince Congress to pass a tax on capital gains at death.
In his campaign and again as part of his American Families Plan, Biden said he’d raise the top individual income tax rate to 39.6 percent plus an additional 3.8 percent Affordable Care Act tax. Biden also wants households with annual income of $1 million or more a year to pay that rate on long-term capital gains. But under current law, those households could avoid the hefty tax by holding on to their assets and passing those unrealized gains on to their heirs tax-free.
We’ll know more details when Biden releases his budget on Friday, but it appears he would address this avoidance problem by taxing at death unrealized capital gains that exceed $1 million ($2 million for married couples) plus the existing housing exemption. In other words, assets passed to heirs would be treated as though they’ve been sold, and gains in excess of $1 million would be taxed.
Assets but little income
For a relatively small number of decedents, this plan could run headlong into Biden’s promise to not raise taxes on those with incomes below $400,000. Of course, the vast majority of decedents will have unrealized gains of far less than $1 million. Indeed, most will leave entire estates far below that threshold. Among people over 70, about 83 percent live in a household with total net worth of less than $1 million.
But some people with large unrealized gains will have been living on relatively low incomes. Imagine someone who is retired and living on Social Security, a modest pension, and some savings. But they still are holding that Microsoft stock they bought in 1987.
To see how many there are, Rob looked at the 2019 Survey of Consumer Finances (SCF), and after adjusting for inflation, combined it with the 2016 and 2013 surveys. This Federal Reserve Board survey has the best information available on both wealth and income.
As Howard pointed out in a recent blog, the US government has no single definition of income. For these purposes, the Federal Reserve Board uses a definition similar to gross income reported on tax return. It includes wages; business and farm income; interest, dividend, and capital gains income; transfer payments; Social Security income; withdrawals from retirement accounts such as IRAs; and income from other tax-deferred pension accounts. The Fed leaves out deductions or exclusions that normally would be used to calculate taxable income.
We could not directly measure the effect of Biden’s plan on decedents, or even the very old since there are so few of them in the survey. As a close proxy, Rob looked at households headed by someone at least 70 years old. And he found that less than 3 percent would face Biden’s tax on unrealized gains if they passed away in the survey year. But about two-thirds of them have SCF income of less than $400,000. More than half still appeared to be working since they reported business and farm income. Thus, an additional number would likely fall below the $400,000 cutoff after they retire but before they die.
Biden can’t solve this problem by raising the threshold for taxable gains by any reasonable amount. If he doubles the exemption to $2 million ($4 million for joint filers), he could reduce the number of those age 70 and older who would pay the tax but still not eliminate them. Nor could he fix the problem by redefining income in some way.
The problem is that retirees tend to have lower incomes than workers, and some of those retirees inevitably will have a lifetime of unrealized gains that amounts to millions of dollars. Biden is right: Those gains should be taxed. But his no-tax pledge on those making $400,000 or less will make it hard.