The Capital Gains Tax and Middle-Class America: The Long and Short (Term) of It

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One of the most controversial and misunderstood aspects of the American tax code is the capital gains tax. Supporters of this tax view it as a necessary way to gain revenue from investment-related capital gains made by the wealthy. However, nearly everything a person owns is theoretically an IRS-defined capital asset, so anyone, even the average middle-class family, can be affected by this tax.

What (and How Much) Are Capital Gains Taxes?

A capital gain or loss is the difference between the selling price (or disposition) of business or non-business assignable property—such as real property, patents, bonds, vehicles, and debts—and the cost to purchase the property (or cost basis). While much of what a person owns (stock portfolios, a collectible car, a vacation home, etc.) may be subjected to capital gains taxes, not everything is. Exclusions include tradable stock and raw materials used for business purposes, personal effects, rural agricultural lands, and up to $250,000 ($500,00 if filing jointly) of the selling price of your primary residence.

Capital gains come in two forms and are taxed differently: short-term and long-term capital gains. Short-term capital gains, which are assessed after less than a year of ownership, are taxed at the seller’s ordinary rate of taxation. Long-term gains, however, are typically taxed at a significantly lower rate. For example, those who fall in the lowest two federal tax brackets, 10 and 15 percent, are charged zero percent for their long-term capital gains, while those in the highest bracket, ordinarily taxed at 39.6 percent, would see a drop to about 20 percent.

Today, the average capital gains tax rate across the 50 states is 28.7 percent when combining top marginal rates at the federal, state, and local levels, according to the Tax Foundation. California and New York charge the highest combined rate at 33 and 31.5 percent, respectively, whereas states with no income tax hold the lowest rate of 25 percent.

The Worth of the Tax

Those in favor of lowering the capital gains tax believe that a high tax rate punishes investment and savings, which are essential for infrastructure growth and job creation. “After the devastating dot-com bust and terrorist attacks of 2001, annual growth averaged just 1.8 percent. But after George W. Bush gradually cut the [capital gains] rate (from 21.19 percent to 16.4 percent by 2003) average annual GDP growth increased a full percentage point, to 2.8 percent,” according to Human Events. Similar effects can be measured after capital gains tax cuts were put into effect by Bill Clinton and Ronald Reagan.

Opponents of the tax also view it as double taxation, because property taxed as a capital gain would already have been purchased with taxable earned income or been subject to a gift tax. Additionally, capital gain calculations do not factor in inflation, so an assumed gain in value may not correspond to real dollars.

Proponents of a high capital gains tax rate, however, argue that higher income households are more likely to own capital assets, and the act of instituting a low long-term capital gain tax rate offers the wealthy a preferential tax rate on their income that is lower than the tax rate most of the middle class enjoys. Proponents also suggest that the correlation between low capital gains tax rates and economic recovery does not necessarily suggest causality and may show a negative relationship.

Regardless of the debate, capital gains taxes are a reality that affects many families, although they are rarely discussed or prepared for. As part of sound tax planning, it’s important for every family to understand what their capital assets are and have a clear understanding of their assets’ tax obligations.