July 8, 2021

State vs. federal capital gains taxes — here's what you need to know before the year ends

Recently, Gov. Inslee signed into law a new capital gains tax applicable to Washington state residents or tangible property held in Washington state. Prudent investors should understand the differences between the new Washington state capital gains tax and the federal capital gains tax to determine whether they need to adjust their financial plans accordingly.

The first notable difference between the two capital gains taxes is the rate at which they are assessed. The Washington state capital gains tax is a flat 7% tax, whereas the federal rate varies from 0% to 23.8%, including the 3.8% Medicare surtax on net investment income.

The biggest takeaway regarding the new Washington state capital gains tax is the threshold of $250,000 of capital gains, regardless of whether the taxpayer is filing an individual or joint return. That means for the purposes of managing tax liability, there is only that one threshold to consider. Washington residents with capital gains below that threshold are not subject to the tax.

Here are a few examples of how the Washington state tax is only triggered once a taxpayer's capital gains exceed $250,000, as opposed to their taxable income. If a professional athlete makes $10 million per year in income, but only $249,999 of that income is considered capital gains, they would not pay any Washington state capital gains tax. On the other hand, a software engineer earning a salary of $200,000 who decides to diversify out of their company stock and recognizes $400,000 in long-term capital gains would owe an additional 7% flat tax on the $150,000 of capital gains above the $250,000 threshold.

Fortunately, the new Washington state tax does not apply to as many categories of assets as the federal capital gains tax does. Real estate, assets held in retirement accounts, tangible property used in a trade or business prior to its sale, interests in qualified family-owned small businesses, and some other less common types of assets are excluded from the Washington state tax calculation. Pass-through entities and trusts are also not subject to the Washington state tax; however, the individuals who have interests in those entities may be subject to the tax based on their personal situation. In addition, taxpayers who make charitable contributions in excess of $250,000 may deduct up to $100,000 against the Washington state tax as long as the contributions are made to a Washington-based charitable organization.

Another point of confusion for some investors is the impact the location and nature of their assets may have on their tax liability. Generally, long-term capital gains and losses from the sale of tangible personal property are subject to the Washington state tax if the property was in the state at the time of the sale. However, long-term capital gains that are the result of the sale of intangible personal property are only subject to the tax if the taxpayer was domiciled in Washington state when the sale took place.

Several lawsuits have already been filed that challenge the Washington state tax on the basis that it violates the state constitution's prohibition of enacting an income tax. To avoid this, the law attempts to characterize the tax as an excise tax imposed on the sale of capital assets rather than an income tax. Whether or not the tax goes into effect in 2022 remains to be seen and will play out in the courts over the coming months.

Although it is estimated that only 0.1% of state residents will pay the tax, it will disproportionately impact taxpayers with significant capital gains embedded in financial assets, such as publicly traded stock. While the likelihood of the tax withstanding court challenges is up for debate, it would be a good idea for those individuals with large amounts of embedded capital gains to reach out to their tax advisor before the end of the year.

Brian Bruggeman, CFP, is vice president and director of financial planning at Baker Boyer Bank in Walla Walla.