In the spring of 2021, Washington State enacted a 7 percent capital gains tax on some taxpayers’ long-term capital gains starting in 2022.
A short time after the capital gains tax became law, a lower court ruled the statute unconstitutional. That decision muddied the waters.
But on March 24, 2023, the Washington State Supreme Court ruled the capital gains tax is constitutional. 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…
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.
An important point: Individuals pay the tax on their directly owned long-term capital gains and on the share of beneficially-owned long-term capital gains realized in a pass-through entity (like a regulated investment company, partnership or S corporation). But trusts (except for grantor trusts which are pass-through entities), estates, C corporations and exempt organizations don’t pay the tax.
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 already see the Washington State Department of Revenue struggling to administer this new tax law as it learns how to apply complex federal tax laws for the first time. (The most recent regulatory guidance, published on July 6, 2023 shows several “holes” for common taxpayer questions, including one our office asked the agency about.)
Washington State Capital Gains Tax Exemptions
The Washington state capital gains tax exempts long-term capital gains on:
- Real estate (if held directly and sometimes if held 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
Two wrinkles that will surely surprise many taxpayers and tax preparers: First, 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 exempt gains (which are not taxed) and non-exempt gains (which potentially are.) The statute and the administrative rules direct taxpayers to include documentation substantiating the fair market value and basis of real estate gains (so an appraisal or possibly an assessor’s report), ownership percentages (so pass-through entity K-1s or possibly formation documents), and then descriptions of the methodology used for the accounting. The statute explicitly authorizes the Washington Department of Revenue to prescribe additional filing requirements.
Note: Taxpayers and tax practitioners familiar with the Washington state estate tax return will recognize that, as is the case with Washington state estate tax returns, Washington state capital gains tax returns work more like a federal tax audit and filing an individual tax return.
Second, the state levies large penalties for late or incomplete filings or for late payment of tax. For example, if taxpayer owed and timely paid capital gains taxes but failed to include documentation (perhaps a copy of the federal tax return, an appraisal report from a state-approved appraiser or an explanation of the methodology used to calculate exemption amounts), the state may levy a five percent penalty for up to five months. If a taxpayer pays her or his tax late? The late payment penalty equals nine percent for missing the deadline, another ten percent for not paying within a month of the deadline, and then another ten percent for not paying with two months of the deadline.
Note: Per the statute, the Department of Revenue “must waive or cancel a penalty if a taxpayer can persuade the department that the failure to file a tax return by the due date was due to circumstances beyond the taxpayer’s control” or “if the taxpayer has not been delinquent in fling any tax return… during the preceding five calendar years.”
Third, real estate gains can lose their “exempt” status in a tiered structure. For example, if you own an LLC which owns and sells real estate for a gain, you pay no Washington capital gains tax. However, if you own a first LLC which in turn owns a second LLC, and that second LLC sells real estate for gain? That real estate gain loses its exempt status by the time it trickles through onto your individual tax return. (Advance planning, by the way, may allow taxpayers to escape this harsh treatment: Per the administrative rules, the taxpayer can dissolve the “second LLC” before the sale no second tier exists.)
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 in 2022. (This $10 million value is adjusted up for inflation in future years.)
Example 1: An entrepreneur residing in Washington state sells her $10-million-in-revenue business in 2022 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.
Note: We’ve published a detailed post about how this deduction works here: Qualified Family-Owned Small Business Deduction.
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 note that the standard deduction 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.)
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. (A resident by the way is someone either domiciled in Washington state or someone who spends more than half the year in the state and who owns an “abode.”)
Washington state residents pay the 7 percent income tax on essentially all of their non-exempt long-term gains in excess of their deductions. 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 in 2022, she pays the 7 percent tax on $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 on intangible property property.
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 in 2022 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.
More complicated rules apply to tangible personal property. Because it can be moved into and out of the state.
A capital gain on the sale of tangible personal property located in Washington state at the time of sale would be taxed potentially both to residents and nonresidents.
A capital gain on the sale of tangible personal property located outside the state at the time of the sale would be taxed potentially if the property had been “inside” Washington state during the current or previous calendar year, the taxpayer is a Washington resident at the time of the sale, and taxpayer is not subject to an income tax on the gain by another jurisdiction.
A Trap in Treatment of Carry Forwards
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. Assume that she also enjoys $1,000,000 of short-term capital gains in year 2, and suffers $1,000,000 of short-term capital losses in year 2. Though she “breaks even” each year and over the two years, she may pay substantial Washington state capital gain taxes in year 2. The reason? The Washington capital gain tax formula looks only at that $1 million long-term capital year in year 2.
Note that had the taxpayer from Example 6 been able to bunch her long-term gains and long-term losses in the same year, she might have avoided paying taxes entirely.
Planning Ideas for Washington’s New Capital Gains Tax
Investors and entrepreneurs probably want to consider a handful of tax planning gambits for the new law, including:
- Delaying taxable losses until these losses can shelter gains. For example, delaying short-term capital losses until they become long-term capital losses and so can shelter long-term capital gains. And delaying long-term capital losses until they can easily and fully be netted with long-term capital 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. And you want to plan ahead. Way ahead.
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 complex and 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.)
Four things to note: First, you and your preparer will need an online SAW account with and you will also need 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. Fourth,if you extend your federal income tax return, you need to confirm and prove that federal extension with the state before the tax deadline to get your state-level extension.
Other Resources
The full text of the new bill appears here: Engrossed Substiture Senate Bill 5096
The July 6, 2023 draft of the Department of Revenue’s regulatory guidance appears here: Preproposal Statement of Inquiry.
The Supreme Court ruling overturning that lower court decision appears here.