Welcome back gang!
Last week we dove into salaries and wages, this week we’ll discuss capital gains taxes.
In the US, you can see that of income available to tax, salaries and wages make up the vast majority of that income. Like we discussed last week, that’s why salaries and wages make up the majority of federal tax revenue in the US. Capital gains, Net business income, and taxable pensions, annuities, and IRA distributions all make up around one and a half trillion of available money to tax each.
What I mean when I say available to tax is that the IRS sees a clear path to tax. For your income each paycheck, congress essentially says, some portion of that you need to give to the federal government. When it comes to capital gains, congress only taxes realized capital gains.
There is often discussion of taxing unrealized gains, but let’s explain what realized means before we discuss that.
If you buy an asset for $100, and then sell that asset for $150, you have a capital gain of $50. Congress says that $50 is available to tax. That’s called a realized capital gain.
If you buy an asset for $100 and then sell that asset for $75, you have a capital loss of $25. Congress will often allow you to deduct that $25 from your other capital gains and in some cases your salaries and wages. This being a case of congress being reasonable.
Often what happens, and the best investors behave this way (this is an investment substack after all) is that an investor buys an asset for $100, and its market price rises to $150, and the investor holds that asset and doesn’t sell it or buy more. They call this an unrealized capital gain. On the same token, you can have an unrealized capital loss.
If you buy two stocks, and 1 goes up $50, and one goes down $25, you can realize both of those gains by selling your stock, and then you would report a capital gain of $25. If you only sold the stock that went up, you would only report a $50 gain, if you only sold the stock that dropped, you would only report a $25 loss. As you can imagine, many people own multiple stocks and each year they might buy or sell them multiple times. We won’t cover wash sales here but even how long you own a security the congress says impacts your taxes.
An accountant can help you figure out exactly what your gain or loss is in any investment, although with the stock market your brokerage platform will likely do it for you, as most are required to.
Now that we understand what a capital gain is, we can talk about how they are taxed.
This part can be a tad tricky. Remember your AGI from the previous section? Where we take your wages and subtract either your write offs or the standard deduction. That’s where we start here. If your wages are $100,000, and you have $25,000 of capital gains, you would look at this chart and say, “I have $125,000 AGI, and that means my $25,000 of capital gains will be taxed at 15%, while my $100,000 of wages will be taxed at their corresponding ordinary income bracket.” The ones discussed last week.
It can also get interesting when your capital gains push you into the higher capital gains bracket. Presume you earn $450,000 in wages and earn $100,000 of capital gains. You will pay 15% on $10,750 of gains, and 20% on $90,250 of gains. The reason for this is to ensure you are never disincentivized to earn more money. Which is clearly a good thing for the economy and society.
The above rates apply to any capital gain that has been held for over 1 year. If you hold an asset for under 1 year, you are taxed at ordinary income rates. Which if you remember form last week, can be much higher. This is an incentive to hold assets for more than a year.
Capital gains rates produce around $160 billion in federal tax revenue. Not a small amount, but nothing very large either.
Many high-net-worth people make considerably more income from capital gains than they do from wages. This might be due to a large net worth, or in some cases due to their pay structure. In private equity for example, the carried interest loophole allows some people to take all of their income in the form of a capital gain (by the way, I don’t intend to imply a bias against the carried interest loophole by calling it a loophole, but I believe that’s what it is only known as, correct me in the comments if I’m mistaken).
Now, in order to partly address the fact that some earners make very large incomes in the form of capital gains (in extreme cases billions a year), congress created the Alternative Minimum Tax (AMT). This tax basically says if you earn too much in capital gains, your total effective tax rate must equal at least 26% or 28%, depending on your income.
I can understand why we have a separate tax bracket for capital gains. It gets harder for me to understand why we don’t have more brackets. Meaning, at some level I think everyone would agree that a higher tax rate is OK. For example, if you have $100,000,000 and invest for 10 years earning 8%, you might earn $110,000,000 in capital gains. That gain might be taxed at 28% as a capital gain as opposed to 37% if it were wage income. This is one, of many, reasons why people often enjoy being paid in stock, the income is in the form of a capital gain.
An often-discussed solution to the national debt is taxing unrealized capital gains. There are likely over $10 trillion of unrealized capital gains annually in the US, so you can argue it is a huge potential tax basis. But it comes with, in my opinion, very serious consequences.
If it’s a publicly traded stock, the value of the stock might rise or fall by huge dollar amounts every day, sometimes by the second. What would congress tax you on? Your gain from the calendar year? In publicly traded stocks with market prices that theoretically could work well, although I would argue you’re discouraging the best type of behavior in the stock market, that being holding for long periods of time. But what about a private company? If an investor where to invest $250,000 into my company, what is the value of that investment in 10 years? If we don’t go public, how will you know? Will congress get in the business of appraising private businesses? That could work and certainly there’s easy enough formulas they could use, although they wouldn’t be perfect. But if you invest $250,000 into my business and in 10 years it’s worth $8,000,000, and say they determine that you owe a 28% tax on your gain, what if the investor doesn’t have $2,170,000 in cash to pay the tax? They would be forced to either take on debt, or sell some of the business. In a publicly traded stock that is fairly easy to do, but in a private business, would you have to find a private buyer for your share of the business to raise the cash for the tax? And would this happen every year? I personally don’t like the idea of congress forcing private businesses to take on additional partners just to pay a tax. It’s not impossible, but I don’t think it is in the best interest of the corporate health of American business, or society.
See you next week.
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Table of contents:
Captial Gains Taxes 202