If you are a high net worth individual (HNWI) with a large portfolio of investments, you may have heard of the term “unrealized gains” or “unrealized capital gains”. These are the increase in value of your assets that have not yet been sold, such as stocks, bonds, real estate, or collectibles. Under current tax law, you do not have to pay taxes on these gains until you sell them and realize the profit.
However, this may change soon. The Biden administration has proposed a new tax policy that would require some of the wealthiest Americans to pay taxes on their unrealized gains every year, even if they have not sold their assets. This is part of the plan to finance a social spending bill and reduce wealth inequality in the country.
In this article, we will explain what unrealized gains are, how they are different from capital gains, why they are a hot topic nowadays, who will be affected by the proposed tax, and how you can approach this potential tax change strategically. We will also introduce you to Kubera, a powerful tool that can help you track and manage your wealth and plan for your taxes.
What are unrealized gains?
Unrealized gains or unrealized capital gains are the increase in value of your investments that have not yet been sold. For example, if you bought 100 shares of Apple stock for $100 each and they are now worth $150 each, you have an unrealized gain of $5,000. You do not have to pay taxes on this gain until you sell your shares and realize the profit.
Unrealized gains can also apply to other types of assets, such as real estate, art, jewelry, or cryptocurrencies. As long as you own these assets and they appreciate in value, you have unrealized gains that are not taxable.
Proposed tax could impact HNWIs
The Biden administration has proposed a new tax policy that would require some of the wealthiest Americans to pay taxes on their unrealized gains every year, even if they have not sold their assets. This is part of the plan to finance a social spending bill and reduce wealth inequality in the country.
The proposed tax is called the “Billionaire Minimum Income Tax” and it would apply to households with net wealth over $100 million or three straight years of income over $100 million. These households would have to pay a minimum effective tax rate of 20% on their “full income”, which includes both their ordinary income and their unrealized capital gains.
For example, if a household has $200 million in net wealth, $5 million in ordinary income, and $10 million in unrealized capital gains in a year, their full income would be $15 million. Their effective tax rate would be 12% ($1.8 million in ordinary income tax divided by $15 million). To increase their effective tax rate to 20%, they would have to pay an additional $1.2 million in tax on their unrealized gains.
The proposed tax could generate $360 billion in new revenue over 10 years from about 20,000 households in the country. More than half of this revenue would come from about 700 billionaires who have large unrealized gains in their investments.
The Current Climate of Wealth in America
The proposed tax on unrealized gains is a response to the growing calls to tax the ultra-wealthy more fairly and effectively. According to data from the Federal Reserve, the top 1% of households in the U.S. held more than 30% of total wealth in 2020. This share has increased from about 24% in 1989.
Meanwhile, some studies have shown that the very wealthy pay low effective tax rates when including unrealized gains as income. For example, a report by ProPublica found that the 400 richest families paid a rate of 8.2% on $1.8 trillion in income from 2010 to 2018 when taking into account a broader definition of income that includes unrealized gains. By contrast, the average American household paid about 14% in federal taxes over the same period.
The Biden administration and some Democratic lawmakers argue that taxing unrealized gains is a way to make the tax system more progressive and equitable. They also claim that it would raise revenue to fund social programs such as health care, education, child care, and climate change mitigation.
However, some Republican lawmakers and legal experts oppose the idea of taxing unrealized gains. They argue that it is unfair, impractical, or unconstitutional. They say that it would impose a heavy burden on taxpayers who may not have the cash to pay the tax, force them to sell their assets at a loss, or discourage them from investing and innovating. They also question the legality of taxing income that has not been realized, citing the 16th Amendment and a Supreme Court case that ruled against taxing unrealized gains in 1920.
What is ‘Unrealized Gains Tax’?
Unrealized gains tax is a proposed tax on the value increase of unsold assets. It is not a current law, but a potential policy change in Biden’s 2023 budget proposal.
Currently, unrealized gains are not taxed. Assets are taxed at capital gains or federal income tax rates when sold. Inherited assets get a “step-up” in basis, which means no taxes on lifetime gains.
The proposed tax would make some wealthy households pay 20% tax on their unrealized gains every year, even if they don’t sell their assets. They would report their asset values yearly and pay taxes on the difference. The tax would be credited against future capital gains tax.
The proposed tax would only apply to households with net wealth over $100 million or income over $100 million for three years. Net wealth and income would include all assets and sources owned by the household.
The proposed tax would also have some special rules and exceptions, such as:
- Deferring the tax payment for up to nine years if cash or liquid assets are insufficient.
- Excluding some unrealized gains from primary residence and charitable donations.
- Deducting some unrealized losses from taxable income.
- Using a special valuation method for illiquid assets.
- Electing an alternative minimum tax calculation with lower rate and fewer deductions.
Why Are Unrealized Gains Tax a Hot-Topic Nowadays?
Unrealized gains tax is part of Biden’s plan to fund a social spending bill and reduce wealth inequality. The bill, also known as the Build Back Better Act, is a $1.75 trillion package of programs and policies for health care, education, child care, and climate change.
The bill passed the House in November 2021 but stalled in the Senate due to disagreements among Democrats. Some moderate Democrats worried about the deficit, debt, and taxes.
Biden proposed several ways to raise revenue from the wealthy and corporations for the bill. One way is the unrealized gains tax, which could generate $360 billion over 10 years from about 20,000 households.
The unrealized gains tax has also caused debate and controversy. Some support it as a way to make the tax system fairer and fund social programs. Others oppose it as a way to hurt success and innovation and the economy.
The unrealized gains tax is also facing a legal challenge in the Supreme Court. A case called Moore v. United States will be heard by the justices in October 2023. The case challenges the constitutionality of taxing unrealized gains under the 16th Amendment, which allows Congress to tax income.
The outcome of this case could affect the unrealized gains tax and other wealth taxes in the future. If the Supreme Court rules for the plaintiffs, it could limit Congress’s power to tax unrealized gains and other wealth. If the Supreme Court rules for the government, it could allow more taxation of the wealthy and their assets.
Who Will Be Affected By Unrealized Gains Tax?
Unrealized gains tax would mainly affect billionaires and other ultra-rich who have large gains in their investments. The White House says the tax would apply to about 20,000 households with net wealth over $100 million or income over $100 million for three years. These households have over $5 trillion in wealth, more than the bottom 50% of Americans.
Unrealized gains tax would not affect most Americans with modest or moderate wealth or income. The tax would exclude some gains from primary residences and charitable donations. The tax would also allow taxpayers to defer paying the tax on unrealized gains for up to nine years if they lack cash or liquid assets.
Some critics of unrealized gains tax argue that it could affect more taxpayers than expected. They claim that the tax could create a slippery slope for taxing lower wealth or income, as well as other assets or transactions. They also warn that the tax could have negative consequences for the economy and investment, such as discouraging innovation, entrepreneurship, risk-taking, saving, and growth.
Unrealized Gains vs Capital Gains
Unrealized gains and capital gains are two different concepts in taxation. Unrealized gains refer to the increase in value of assets that have not yet been sold, such as stocks, bonds, real estate, or collectibles. Capital gains refer to the profit made from selling assets that have appreciated in value.
Under current tax law, unrealized gains are not taxed until they are realized through a sale. Capital gains are taxed when they are realized through a sale. The tax rate for capital gains depends on how long the asset was held before selling and the taxpayer’s income level. For most assets held for more than one year, the long-term capital gains tax rate ranges from 0% to 23.8%, depending on the taxpayer’s income level. For assets held for less than one year, the short-term capital gains tax rate is equal to the ordinary income tax rate, which ranges from 10% to 37%.
Under the proposed tax on unrealized gains, some of the wealthiest households would have to pay taxes on their unrealized gains every year, even if they have not sold their assets. They would have to pay a minimum effective tax rate of 20% on their full income, which includes both their ordinary income and their unrealized capital gains. The tax would be treated as a prepayment of future capital gains tax liability, meaning that it would be credited against the taxes owed when the assets are eventually sold.
Unrealized Gains Tax and High Net Worth Individuals
Unrealized gains are a big part of wealth for high net worth individuals (HNWIs). A report by Wealth-X, a wealth intelligence firm, said HNWIs had an average net worth of $9.6 million in 2020. About 60% was in financial assets like stocks, bonds, funds, etc., while about 15% was in non-financial assets like real estate, art, jewelry, etc. These assets tend to grow in value over time.
The Wealth-X World Ultra Wealth Report 2020 said the global UHNW population had an average net worth of $122 million in 2019. About 60% was in financial assets, while about 15% was in non-financial assets. The rest was in cash or cash equivalents.
The unrealized gains tax could raise the taxes owed by HNWIs. They could face a tax rate of up to 43.4% on their unrealized gains (20% minimum tax plus 3.8% net investment income tax plus 20% state and local taxes). This would be higher than the current maximum long-term capital gains tax rate of 23.8%.
The unrealized gains tax could also affect the investment behavior and decisions of HNWIs. They may have to sell some assets to pay the tax, which could trigger more taxes and costs. They may also have to change their asset allocation and diversification strategies to reduce their unrealized gains or seek more tax-efficient investments. They may also have to rethink their estate planning and philanthropic goals, as the tax could reduce the wealth they can pass on or donate.
Approaching Potential Tax Changes Strategically
Given the uncertainty and complexity of the proposed tax on unrealized gains and other potential tax changes, HNWIs need to approach their wealth management and tax planning strategically. They need to have a clear and comprehensive view of their net worth, income sources, asset holdings, liabilities, expenses, and goals. They also need to monitor the market trends, policy developments, and legal challenges that could affect their wealth and taxes.
This is where Kubera can help. Kubera is a powerful tool that can help HNWIs track and manage their wealth and plan for their liabilities. Kubera allows HNWIs to:
- Connect all their bank accounts, investment accounts, savings accounts, retirement accounts, DeFi assets on multiple chains, and other financial assets in one place.
- Add their non-financial assets, such as real estate, art, jewelry, collectibles, businesses, etc., with manual or automated valuation methods.
- See their net worth, income, expenses, cash flow, asset allocation, diversification, and performance at a glance.
- Estimate their potential taxes on unrealized gains.
- Set up alerts and notifications for important events or changes in their wealth.
- Use the fast forward feature for financial planning based on different scenarios and assumptions.
- Share their wealth information securely with their family members or beneficiaries in case of an emergency or death.
Kubera provides HNWIs with a holistic view of their wealth and helps them make informed and strategic decisions to optimize their wealth and taxes.
Minimizing Liability: Four Possible Strategies to Offset Impact of Unrealized Gains Tax
If the proposed tax on unrealized gains becomes a reality, HNWIs may want to explore some possible strategies to minimize their tax liability and offset the impact of the tax on their wealth. Some of these strategies include:
- Tax-loss harvesting: This involves selling assets that have declined in value to realize capital losses that can offset capital gains or ordinary income. This can help lower the taxable income and reduce the minimum tax on unrealized gains. Tax-loss harvesting can also help rebalance the portfolio and align it with the investor’s risk tolerance and goals.
- Asset shifting: This involves shifting investments from certain vehicles that generate high unrealized gains or taxable income to others that offer more tax benefits or deferrals. For example, HNWIs could move some of their funds from mutual funds or exchange-traded funds (ETFs) that distribute capital gains to shareholders to individual stocks or bonds that do not. Alternatively, they could invest in real estate or other assets that offer tax benefits, such as depreciation, deductions, or exemptions.
- Estate planning: This involves creating a plan to transfer wealth to heirs or beneficiaries in a tax-efficient manner. For example, HNWIs could use trusts, such as revocable trusts or irrevocable trusts, to protect their assets from creditors, lawsuits, or probate. They could also use life insurance policies to provide liquidity and tax-free income to their heirs or beneficiaries.
- Philanthropy: This involves donating wealth to charitable causes or organizations that align with the values and goals of HNWIs. This can help reduce the taxable income and estate of HNWIs, as well as create a positive social impact and legacy. For example, HNWIs could use donor-advised funds, charitable trusts, or private foundations to make tax-deductible donations and control how their funds are distributed.
These strategies are not exhaustive or definitive. They may have different pros and cons depending on the specific situation and goals of each HNWI. They may also require professional advice and guidance from experts in wealth management, tax planning, estate planning, and philanthropy.
Conclusion
The proposed tax on unrealized gains could affect the wealth and taxes of HNWIs. It is part of Biden’s plan to fund a social bill and reduce inequality. It is also debated and challenged by various groups.
HNWIs need to know their net worth, income, assets, liabilities, expenses, and goals. They also need to monitor the market, policy, and legal changes that could affect them. Kubera can help HNWIs track and manage their wealth and liabilities, including taxes on unrealized gains. Kubera allows HNWIs to connect all their assets, see their financial situation, set up alerts, access expert advice, and share their wealth information securely. HNWIs can also use the fast forward feature in Kubera for financial planning based on different scenarios and assumptions.
HNWIs can also explore some strategies to minimize their taxes and offset the tax on unrealized gains. These strategies include tax-loss harvesting, asset shifting, estate planning, and philanthropy. These strategies may vary depending on the HNWI’s situation and goals. They may also need professional help from experts.
The tax on unrealized gains is not a law but a potential change that could impact HNWIs. HNWIs need to be ready for this and take steps to optimize their wealth and taxes. Kubera can help them with this by providing a tool that can help them with their wealth and plan for their future.
