The unrealized capital gains tax has been widely discussed lately, especially after it was mentioned among new potential laws in the USA. Most people are not aware of it and the truth is they are less likely to be affected anyway. Who does it affect then?
This type of tax is most likely aimed at the rich – billionaires or those with high-value assets. You do not need to be a billionaire to be affected. Instead, you might as well own a few properties or perhaps some collectibles.
To the average individual, this tax means nothing, yet there are people out there who are happy to see the rich paying more taxes. To the rich individual, this tax may seem a little abusive. Will it go through? Only time can tell. But before getting there, it is imperative to understand how it works.
How gains and losses target the investment industry
Gains and losses are perfectly normal in the investment industry. Investments are like bets. Sometimes you win, other times you lose. Many of these winnings are temporary, not to mention the losses – basically, markets fluctuate and value comes and goes.
Investors spend their money with one goal in mind – raking up the actual gains. Practically, you want to spend small amounts of money to purchase an asset, wait until it gains value and get rid of it. The profit is yours. The value may also go down based on different circumstances.
Now, how do you define these gains? Simple – if the value of the asset is higher than when it was initially bought, you have a gain. A loss occurs when the price is lower than the initial one. It is all about gaining in value or losing value.
Now, here comes the interesting part. A gain or loss can be realized on unrealized. To understand the unrealized capital gains tax, you need to figure out what realized or unrealized gains or losses are. A gain or loss is realized when you actually get rid of the asset – basically, you sell it.
The gain or loss is unrealized when the value has changed, but you still hold it. For instance, you get a nice watch. It gained in value over the past few years. You still have it because you like it or you think it will gain more. That is an unrealized gain.
Becoming familiar with the unrealized gain
The value of a particular asset may change when least expected. It makes no difference if you sell it or plan to do so. There are many more circumstances that could affect the value. The gain is realized when you make money out of it.
For example, you buy a house for $150,000 and sell it years later for $200,000. You have a profit at this point. Different industries have different trends – the real estate one keeps gaining in value. But other industries may have higher risks of loss with time.
The gain is unrealized if you still hold on to the asset. The price is higher – great, but you still want to keep it. You believe the price is likely to get even higher, or you simply keep it as an investment – you do not need to get rid of it right now.
When you think about the richest people in the world, they do not have billions in cash. Many of them rely on unrealized gains in order to figure out how their investments are doing. Such gains allow them to make more informed decisions regarding the perfect time to sell or whether they should keep assets for longer.
It is worth noting that turning unrealized gains into realized gains will bring in some consequences on your tax requirements. Sure, different countries have different rules, but in the USA, you will most likely have to pay some tax.
Understanding how the unrealized loss works
If you know how the unrealized gain works, figuring out the unrealized loss makes sense. It is the opposite. The realized gain and loss work on the same principle. You purchase an asset, and you sell it for less than the original purchase – at this point, you have a realized loss.
When the loss is unrealized, it remains on the books. It is not actually accounted for by you. If the loss stays unrealized, it is usually because the investors expect the price to go back up. Fluctuations occur all the time. If it fails to recover, the asset will bring an even larger unrealized loss to the investor.
Both unrealized gains and losses are also referred to as paper profits or losses for some clear reasons. You do not experience the actual financial loss or gain. You do not feel it – you do not have extra or less money. Instead, it is only on paper.
Tax consequences associated with capital gains
In theory, there is no such thing as an unrealized capital gains tax – most countries do not have such taxes. However, some countries out there could bring something similar in. Moreover, things are different when it comes to realized capital gains.
Normally, you do not have to report anything to the IRS in the USA if you end up with unrealized capital gains. No one seems to care. Your tax return should not include such things either. If the unrealized gain becomes realized, you will have to report it.
Capital gains normally go in two different categories – short and long term. Short term gains are realized when you hold a particular asset for less than a year. The long-term gain is realized when you hold an asset for more than that.
In the USA, you’ll pay 10% if you make less than $11,600 a year as a single individual or less than $23,200 for a couple You’ll pay 12% for anything between $11,600 and $47,150 or double for couples. The list goes up in increments:
- 22% for anything between $47,150 and $100,525 or double for couples
- 24% for anything between $100,525 and $191,150 or double for couples
- 32% for anything between $191,950 and $243,725 or double for couples
- 35% for anything between $243,725 and $609,350, more for couples
- 37% for anything over $609,350, more for couples
Long term income is different and rates can be 0%, 15% or 20%, based on the income.
There are slight differences in these numbers from one year to another, so it pays off doing your homework if you plan to make any financial moves. You can also use capital losses to your advantage and claim them, but you need a good strategy.
You can use them to lower the tax burden associated with gains in the same year, but also the future capital gains. You can also rely on a capital loss to offset ordinary income based on the above-mentioned limits.
In the UK, on the other hand, you will pay capital gains tax – only if they are realized – for personal possessions worth more than £3,000, but with a few exceptions. For example, you will not pay tax on your car.
On the same note, you will pay realized capital gains tax on properties that are not your main homes or even your main home if you have used it for business purposes – such as letting it out. Some shares and business assets will also come with a tax.
For instance, if you make £10,000, you’ll only pay tax for £7,000.
As you can see, different countries have different rules. In theory, most governments will try to tax you again for realized capital gains. But what about the unrealized capital gains tax? Is that even a thing? Believe it or not, the American government brought it into discussion over 2021.
The current government has some impressive spending plans, but no money. Who can they charge then? The rich, of course. They know adding more taxes to the average American will most likely start protests and a revolution, so they target the few rich people who hold valuable assets.
Becoming familiar with the unrealized capital gains tax
The unrealized capital gains tax came into discussion in 2021, when Joe Biden and the Democrats found a new way to tax billionaires. The purpose of this tax was to help the millions of American who needed financial help. But then, there are two groups of people who dislike the idea.
First of all, you have the Republicans. Obviously, they have to contest pretty much everything Democrats come up with – it is just part of being the opposition. Second, billionaires themselves find it unfair to be taxed on profits they do not actually make.
To make it clear, this tax is for the unrealized capital gains and not the realized ones. In other words, you may have a valuable watch. It gains 50% more value over the past year, so you will be taxed for that value, even if you still keep it. Who decides on the value then?
The problem is that this new tax will not cover the income. It will not tax the income. It will tax the unrealized gains, which makes no sense. This is also a game-changer because lots of wealthy individuals gained in net worth by owning assets that gain value.
Sure, they do not sell those assets, but keep them. Their net worth is higher. They have more money in assets, but they do not have the actual money. Generally, at this moment, such assets may include shares in companies, properties, artworks, cryptocurrencies, and so on.
They are not taxed until they are sold. What the government wants to do now is tax them again and again and again, based on the value they get. The question is – what happens if they lose value next year? What happens with the fluctuations?
Something gains $10M in value this year. Fine, someone will pay tax for it. What happens if it loses $5M next year? Will there be a tax return? This is less likely to happen, so the tax is basically an apparently legal way to rob the rich.
Now, how does this unrealized capital gains tax compare to the regular income tax? Try to see it this way… If you make $40,000 a year in your job, you will pay income tax. If a wealthy individual makes $5 million due to assets gaining value, they will not pay tax until they sell them, of course.
What Joe Biden wants to do is tax them on these capital gains, even if there is no profit. What happens if someone does not have so much liquidity to pay millions in tax while their assets keep gaining value? Exactly…
What Democrats are trying to do
Democrats try to change the way assets are seen from a tax man’s point of view. They want to ensure such assets are taxed on a regular basis based on the value they get. They try to tax the unrealized gains by checking the values of different assets at the beginning of the year, as well as the end of the year.
No matter how much value something in particular gains, the Democrats aim to tax it. What happens if the asset loses value then? Will the government pay the respective individual some money in tax return? No one has thought about that, of course. Governments are all about taking, rather than giving.
This plan does not even affect ordinary Americans. You need to make $100M three years consecutively or have a net worth of at least $1B. This plan is likely to affect less than 1,000 people in this range and not the average American.
Why would someone with a business point of view appreciate it? Why would someone who grew a business from scratch be taxed differently? In the age of capitalism, this move brings back some of the aspects associated with dictatorships.
Obviously, there are a bunch of other issues associated with the unrealized capital gains tax. While being widely discussed, most believe that it will not go further – and if it does, there will be ways to avoid it anyway.
Problems associated with the unrealized capital gains tax
The White House released a report to show what the average tax rewards would be. This new code brought in the unrealized capital gains tax – the increase in wealth from one year to another. The methodology is quite bizarre and leaves room for plenty of oddities.
This tax is less likely to become law too soon. For instance, imagine wealth going up this year. It will lower next year. Then, it goes up again, then down. What is the procedure in this case? Will the government pay the money back? Not really.
This new attempt was given by the fact that some of the wealthiest people out there do not pay a fair amount of tax. How come? A few reports aimed to push things in different directions. For instance, it seems that some wealthy families pay tax at preferred rates – especially from stocks and dividends.
Getting to the small figures claimed by the Democrats implies redefining income at all. You would have to change how capital gains are approached as well. Taxing unrealized gains is normally done yearly – or at least this is what the Democrats want.
Now, these families or wealthy individuals are not actually sitting on mountains of gold coins. The wealth is mostly based on assets. Some of them are not liquid – like art or businesses. Some other assets are liquid – bonds and stocks. The extra wealth does not translate into extra money in the bank.
Instead, this growth is on paper only. The current proposal goes even further than that. It would also include real estate, which cannot be considered liquid either. After all, you cannot sell an ultra-expensive house within minutes only – at least not while managing to get a fair price for it.
The market value cannot be tracked daily either. Like other similar assets, properties are a bit imaginary when it comes to the unrealized capital gains tax. No matter what asset you are considering, it does not have a set value.
You cannot put a value on anything – art, cars, houses, anything. The price is only what someone else would be willing to pay for it. A piece of art could be estimated at $10M, but it may be on the market for decades before someone could pay this amount of money on it.
This is why the logical and objective way to get things done is to tax the actual transaction. Otherwise, putting a price on assets that are not liquid would be an actual joke. People would have to guess such values and prices – a big joke and a process that can be easily gamed.
Then, some may ask – what about the preferred rates for taxes? There are some logical reasons behind all these. First of all, the government aims to support the long-term investment, which obviously creates jobs – a plus for the economy. Without this benefit, long term investment would become history.
Second, inflation requires some consideration as well. Preferential rates can help those in charge to avoid taking major risks for investment losses, meaning they will keep pumping money into the local economy – these are some concepts that the average American cannot understand.
Moving on, take a look at the requirements too – $100M in income over three consecutive years or over $1B in wealth. On paper, these things would exclude farmers, dentists, store owners, or other people who are actually wealthy on paper, but do not have too much liquid net worth.
Now, who does the estimates? The rich would ensure they never make $100M for three years in a row. As for their net worth, they would estimate it at under $1B, regardless of the government's estimates. Such discrepancies would lead to long-term and wasteful legal battles.
From an economic point of view, extra net worth would imply paying millions in tax. Where are all these people get their millions from? They do not sit on mountains of dollars, but they keep their money in assets. They would have to sell bonds and stocks in order to pay taxes.
This kind of move will transfer more and more power to overseas investors, who will be the logical buyers – not affected by this new law. You do not have to be an expert to figure it out – this tax is a way to drive money out of the country.
In the long run, such as abusive tax would chase people away. You want more wealth creation, but you are pushing it away – this is what the Democrats are doing without even realizing it. You want to tax entrepreneurship, so you will obviously get less of it.
If you have a million dollar idea and you get to pay the government more than what you pay yourself, why would you even do it anyway? Why would you work for the government? Why would you do it locally, when you could do the same thing in a country that appreciates your work?
Go to the UK – a similar market, the same language, and an environment that encourages business. Go to Ireland, which is even better in terms of taxes. You might as well try out a tax haven. Worried about being taxed as an American citizen? Give your citizenship up.
Bottom line, all these issues will leave plenty of room for misinterpretation. There are lots of loopholes. There are plenty of ways to overcome this problem, ways to reduce net worth, and so on. Plus, you could also grab your toys and move abroad.
The amounts of people renouncing their citizenship have reached record levels in the past year. Some of the most famous people who gave up include Yul Brynner, Denise Rich, Eduardo Saverin, Jet Li and Tina Turner – not to mention plenty of regular business people who do not count as celebrities.
Conclusion
As a short final conclusion, the unrealized capital gains tax has been thrown out in the wind by Joe Biden and the Democrats. It is an idea that they might try to go on with. No one knows the small details – that is what makes the difference, after all.Time will tell whether or not this tax will make it official, but chances are it will not. If it will, it can cause a lot of problems within the local society – even if the average American does not see the direct effect, it will reflect over everyone.
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