In the spring of 2021, Washington State enacted a 7 percent capital gains tax on some taxpayers’ long-term capital gains starting in 2022. Accordingly, individuals living or investing in Washington state need to learn how the law works. And also how to minimize its impact.
A caution? The new law burdens both the state and investors with surprisingly complicated rules…
And then one other complication. One state court has already ruled the capital gains tax is unconstitutional. So right now, taxpayers and tax accountants are waiting for the state’s Supreme Court to make its decision.
Washington State Capital Gains Tax in a Nutshell
The new income tax only hits long-term capital gain or other income the Internal Revenue Code treats as long-term capital gains. Tax accountants will recognize this as Section 1221 gain and some Section 1231 gain.
Further, though the law isn’t that clear, almost any Internal Revenue Code section that excludes or defers recognization of long-term capital gains for federal taxes also excludes or defers recognization of gain for Washington state’s capital gains tax.
For example, Section 1202 Qualified Small Business Stock (more details here and here), Section 351 transfers, and similar statutes probably also exclude or defer gain for Washington state’s new capital gains tax. Interestingly, one deferral that doesn’t work? Qualified Opportunity Zones (more details here).
Note: An awkward but important planning point: One can fairly assume the Washington State Department of Revenue will struggle to administer this new tax law as it learns how to apply complex federal tax laws for the first time.
Washington State Capital Gains Tax Exemptions
The Washington state capital gains tax exempts long-term capital gains on:
- Real estate (whether held directly or indirectly),
- Assets held inside retirement accounts,
- “Cattle, horses, or breeding livestock if for the taxable year of the sale or exchange, more than 50 percent of the taxpayer’s gross income for the taxable year,”
- Property depreciable under Internal Revenue Code sections 167(a)(1) or 179,
- “Timber, timberland, or the receipt of Washington capital gains as dividends and distributions from real estate investment trusts derived from gains from the sale or exchange of timber and timberland,”
- Commercial fishing privileges, and
- Goodwill received from the sale of an auto dealership
A wrinkle that will surely surprise many taxpayers and tax preparers this coming tax season: A pass-through entity that reports Section 1221 capital gains or Section 1231 gains will need to document how and whether those gains break down into real-estate-related gains (which are not taxed) and non-real-estate gains (which are.)
A legitimate worry here? That the return might need to include appraisals or appraisal-like detail. This additional documentation may sound unusual but note that the Washington state estate tax return filing requires this information.
The Qualified Family-owned Small Business Deduction
The tax allows three deductions.
For example, the new tax law provides a deduction for gains from the sale of most family owned small businesses as long as the owner actively operated the firm for the five years preceding the sale of the business and also materially participated in the business.
“Small” for purposes of this deduction means the business recognizes $10 million or less of worldwide revenue.
Example 1: An entrepreneur residing in Washington state sells her $10-million-in-revenue business and realizes a $10 million long-term capital gain. If her business qualifies–and it probably should–she escapes paying Washington state’s capital gains tax.
A heads-up warning here: A slightly complicated set of requirements exists for situations where two or three families (as opposed to a single family) own (or primarily own) the business.
The $250,000 Standard Deduction
The new tax law also provides a $250,000 standard deduction.
Example 2: One of the founders of a Washington technology company realizes a $1,250,000 gain on the sale of her stock in the company. Assuming that $1,250,000 represents her only long-term capital gains for the year, she pays the 7 percent tax on the $1,000,000 gain.
But the standard deduction includes some wrinkles.
First, note that the $250,000 makes no differentiation between single and married taxpayers. Both get the same $250,000 deduction. (Further, the state treats domestic partners as married for purposes of the tax law.)
Second, in a nod to the possibility that some part or all of the new tax will be found unconstitutional, taxpayers add to the $250,000 deduction amount any part of the capital gains tax found unconstitutional under federal or state law.
The Alternative Charitable Deduction
As an alternative to the standard $250,000 deduction, taxpayers can use up to $350,000 of charitable contributions to Washington state nonprofit organizations.
Example 3: An investor realizes $10,250,000 of capital gain subject to Washington state capital gains tax. The investor contributes $1,000,000 to a Washington state nonprofit organization. To calculate the capital gains taxed by Washington state, he may deduct either the $250,000 standard deduction or $350,000 of his $1,000,000 of charitable deductions.
Note: The $250,000 deduction and the $350,000 charitable deduction limit get adjusted upwards for inflation starting in 2023.
Residents vs. Non-residents
The new state law works a little differently for residents than for nonresidents.
Washington state residents pay the 7 percent income tax on essentially all of their long-term gains in excess of $250,000. Both capital gains connected to Washington state and those, in a sense, connected to some other state.
Example 4: One of the founders of a Washington company resides in Washington. If she realizes a $1,250,000 gain on the sale of founders’ stock in the Washington-based company, she pays the 7 percent tax on that $1,000,000 of the gain. If she sells a capital asset located in another state for a $1,000,000 gain, she probably also pays the 7 percent tax on that gain.
Non-residents typically won’t pay the tax however.
Example 5: Another founder in the same Washington-based company referenced in Example 4 lives in Texas. He also realizes a $1,250,000 gain on the sale of founders’ stock in the Washington-based company. But he does not pay the 7 percent Washington state capital gain tax on this gain. Further, if he sells capital assets located in his home state of Texas and realizes another $1,000,000 of gain, predictably, Washington state can’t tax that income.
Note: A nonresident might pay the capital gains tax on tangible personal property he or she moves out of Washington state.
A Trap in Treatment of CarryForwards
One quirk in the way the new capital gains tax works? Capital losses don’t necessarily carry forward.
Example 6: A taxpayer residing outside of Washington state coincidentally suffers a $1 million Washington state long-term capital loss in year 1 and then enjoys a $1 million Washington state long-term capital gain in year 2. Though she “breaks even” over the two years, she may pay substantial Washington state capital gain taxes in year 2.
Note that had the taxpayer from Example 6 been able to bunch her gains and losses in the same year, she might have avoided paying taxes entirely.
Planning Ideas for Washington’s New Capital Gains Tax
Will the new Washington state capital gains tax actually become law? Good question. In the past, state courts ruled income taxes to be unconstitutional. One probably wants to recognize the possibility this law ultimately gets discarded…
However, investors and entrepreneurs probably want to consider a handful of tax planning gambits–and soon–in case the courts accept the new law. And a variety of tax minimization techniques exist, including:
- Realizing taxable gains in 2021 so before the new tax law becomes effective.
- Delaying taxable losses until 2022 or later so these losses can shelter gains.
- Relocating to another state that either doesn’t tax income or taxes the income at a lower rate.
- Starting any new business that incents employees with stock in another state that doesn’t tax income or taxes income at lower rates.
- Using other tax exclusions and deferrals (like Section 1202 Qualified Small Business Stock mentioned earlier) to avoid or delay recognition of federal long-term capital gains.
- Spreading out the recognition of capital gains over multiple years (for example, splitting a $500,000 into two $250,000 chunks recognized in different years)
Which of these options make sense for a taxpayer? Or in a given situation? You want to confer with your tax advisor. Probably after tax season ends given this is at least the third major income tax law change your tax accounant has had to deal with over the last two tax seasons.
How You’ll File and Pay Your Washington State Capital Gains Tax Return
You will electronically file your capital gains tax return using the State of Washington’s “My DOR” portal. The process is simple though potentially cumbersome.
You or your paid preparer enters your name, address, taxpayer identification number, filing status and then all of the detailed information from your Schedule D, Form 8949 and Form 4797. At the end of the filing process, you attach a copy of your federal income tax return and indicate how you want to pay the tax you owe. (Probably you will direct the state to deduct the capital gains tax from your bank account.)
Three things to note: First, you or your preparer will need a capital gains account with the Washington State Department of Revenue. You can get information about how to do this and begin the process here. Second be forewarned that the software does not support an automated way to load large numbers of capital gain transactions. (If you or your client has hundreds or thousands of stock sales, someone will spend hours or days entering this information.) Third, the system does not support in any obvious way paid tax return preparers.
The full text of the new bill appears here: Engrossed Substiture Senate Bill 5096
A draft of the Department of Revenue’s regulatory guidance appears here: Preproposal Statement of Inquiry.