The Washington Legislature passed Senate Bill 5096 on April 25, 2021, the last day of the 2021 Washington legislative session. SB 5096 is a state capital gains tax on individual residents of the State of Washington. The state House approved the bill 52-46; the state Senate approved the bill by a single vote margin, 25-24. Governor Inslee, who proposed a Washington capital gains tax several years ago, said that he will sign the bill into law. We provide answers to a few of the most pressing questions about the Washington capital gains tax.
1. When would the tax commence?
The tax would begin to apply on January 1, 2022; capital gain recognized in 2021 would not be subject to the tax.
2. What is the tax rate?
A flat tax rate of 7% would apply to Washington residents’ net federal long-term capital gain per calendar year in excess of the standard deduction and exemptions.
3. What exemptions and deductions apply to the tax?
The tax applies only to long-term capital gain; ordinary income, short-term capital gains, qualified dividends, tax-exempt interest, and other categories of income are excluded.
A standard deduction of $250,000 is available for each individual and married couple (a married couple shares a single $250,000 standard deduction, or $125,000 for each spouse). Spouses who file joint returns for federal purposes must also file jointly for purposes of the Washington capital gains tax, effectively sharing and dividing equally all gains and losses for the year, while spouses who file separate federal returns must also file separate Washington returns and will have their Washington capital gains tax liability determined separately.
Several categories of assets, some broad and some narrow, are also expressly exempt from the tax. These include real estate, interests in privately held entities to the extent the value is attributable to directly owned real estate, assets held in retirement accounts, assets subject to condemnation proceedings, certain livestock, certain business assets subject to depreciation or expensing, timber, commercial fishing privileges, and goodwill from the sale of certain auto dealerships.
Gains from the sale of certain family-owned small businesses (with less than $10,000,000 in annual revenue) are deductible as well. A modest charitable deduction is available for contributions to Washington charities in excess of $250,000 and is limited to a maximum deduction of $100,000 per taxpayer per year.
4. Who would be subject to the tax?
Individuals who are legally domiciled in Washington are generally subject to the tax, and individuals who are not legally domiciled in Washington are generally not subject to the tax (unless they recognize gain on the sale of tangible personal property located in Washington).
The tax does not apply to corporations or other entities, but individuals to whom capital gains are allocated from pass-through entities such as partnerships and LLCs would be subject to tax on those allocated gains.
5. How would the tax apply to trusts?
Trusts that are taxed as nongrantor trusts would not be subject to the Washington capital gains tax, but Washington beneficiaries of nongrantor trusts who receive allocations of long-term capital gain would be subject to the tax. Capital gains recognized by grantor trusts, of which the trust assets are treated as owned by the grantor for federal income tax purposes, and by nongrantor trusts that would be includible in the grantor’s estate (sometimes called incomplete gift nongrantor trusts), would be allocated and taxable to the grantor.
6. Can voters overturn the tax by referendum or initiative?
The legislature included a provision in the capital gains tax bill designating the tax as “necessary for the support of the state government and its existing public institutions,” which may exempt the law from the voter referendum process. The voter initiative process, which requires double the number of petition signatures and has a shorter deadline than the referendum process for gathering signatures, remains available this year or in future years; to appear on the November 2021 ballot, the requisite number of petition signatures must be submitted by July 2.
7. Is the capital gains tax constitutional?
The Washington State Constitution, Article VII, provides that all taxes on property, defined as “everything, whether tangible or intangible, subject to ownership,” must be uniformly applied and cannot exceed an annual rate of 1%.
In applying these limitations to previously adopted taxes, the Washington Supreme Court has ruled that taxes on gross income or net income are taxes on property subject to the constitutional uniformity and rate limitations. The court has characterized previous efforts to tax the receipt of income as taxes on property that are subject to these constitutional limitations.
In other cases, the court has held that taxes on a particular use or enjoyment of property, or on a voluntary act or privilege as distinct from mere ownership, are characterized as excise taxes not subject to constitutional uniformity and rate limitations.
The new capital gains tax is not limited to 1% (and may not be uniformly applied due to applicable deductions and limitations), so forecasting the current court’s characterization as either a property tax or an excise tax is difficult. No recent precedents squarely align with the structure of the new capital gains tax. The first case to challenge the new tax on constitutionality grounds has already been filed, and a final decision from the court may take a year or longer.
8. How might Washington residents begin to plan for the tax?
There are several planning considerations that taxpayers might consider in anticipation of the possibility that the Washington capital gains tax is not determined to be unconstitutional or overturned by initiative. First, taxpayers might consider changing their residency status; establishing legal domicile in a different state would avoid capital gains tax on intangible assets. Taxpayers may also accelerate capital gains events in 2021 so as to reduce capital gains in 2022 and beyond. Taxpayers anticipating a spike in long-term capital gain income might smooth out their capital gains income stream using charitable remainder unitrusts, or they might make gifts of assets to lower-income beneficiaries (including nongrantor trusts) to minimize the tax.