Here’s a question for you to chew on. It’s more of a riddle, actually: Can you be taxed on something that’s not really real? Thanks to the folks in charge in the White House and Congress, we might find out the answer to that riddle pretty soon.
Back in March, President Joe Biden said he wants to introduce a new tax that targets the wealthiest families in the country.1 It’s called the Billionaire Minimum Income Tax—except that it doesn’t only tax billionaires, it isn’t a minimum tax, and it’s not really a tax on “income” either. But it is a tax . . . so at least they got that part right!
So, what exactly is this Billionaire Minimum Income Tax? In a nutshell, it’s a 20% tax on the unrealized capital gains (hang on to that thought) of American households worth at least $100 million.
To understand how this works—and whether this tax has an actual chance of becoming a reality—we’ve got to talk about unrealized capital gains first. Let’s dive right into it!
What Are Unrealized Capital Gains?
Capital gains—which are profits (or potential profits) from an investment that goes up in value after you buy it—can either be realized or unrealized.
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Unrealized capital gains show you how much your investment has increased in value before you sell it. Once you sell an investment for a profit, you now have realized capital gains.
The difference is that unrealized gains are only on paper—they’re not really real (yet)—while realized gains represent real money that’s now in your pocket. Simple enough, right?
How Do Unrealized Capital Gains Work?
Let’s say you bought a stock today that’s worth $1 and then you just let it sit in your account for a while. You come back exactly one year later to take a look at your account and see that it’s now worth $11.
Whenever a stock or investment you own is worth more than what you bought it for, you can sell it for a profit—and those profits are called capital gains. Congratulations!
If you decide to hold on to the stock and not sell it, then what you have are unrealized capital gains. After all, you can’t just walk up to your grocery store cashier and pay for milk and eggs with your stock—no matter how much it’s worth on paper.
But if you decide to sell that stock and someone buys it from you for $11, you don’t have unrealized gains anymore. Now you have $10 worth of realized capital gains . . . which means now you’ll have to pay taxes on those profits.
How Are Capital Gains Taxed?
Under current tax law, you only pay taxes on the profits you make from an investment after you sell it. In other words, you can only be taxed on realized capital gains. As long as you hang on to your investment, any unrealized capital gains you have remain out of Uncle Sam’s reach.
In most cases, you’ll have to pay capital gains taxes on any profits you make from the sale of an investment, and how much you’ll owe depends on your income and how long you had your investment before you sold it.
For example, if you sold a stock less than a year after you bought it, then you’ll pay the short-term capital gains rate—which is the same as your ordinary income tax rate. But if you waited a year or longer before selling it, you’d pay the long-term capital gains rate—which could be 0%, 15% or 20%, depending on what your income is.
But if President Biden gets his way, unrealized capital gains will no longer be off-limits for the IRS—at least not for the roughly 30,000 American households that are currently worth at least $100 million.2
How Would a Tax on Unrealized Capital Gains Work?
Let’s say you’re one of those Americans with a household net worth of $100 million or more. Again, that stock went up in value by $10 in the one year since you bought it, so you have $10 in unrealized capital gains from that stock.
You decide to hang on to the stock and not sell it, which should protect you from paying taxes on those gains, right? Wrong! Under this new plan, you’d have to pay a 20% tax on those unrealized gains in the year those gains occurred. In this case, you would owe $2 to the IRS.
Does this mean you’d be taxed on those capital gains again if you decide to sell the stock? No, not exactly. You see, the Treasury Department says this tax would act like a “cash advance” on any capital gains taxes you might owe when you sell your investments in the future.
For example, suppose another year passes by and that stock we’ve been talking about is now worth $15. If you decide to sell, you'd now have $14 in realized capital gains. At a long-term capital gains tax rate of 20%, you would owe $2.80 in taxes on those gains. But since you already paid $2 in taxes on those gains when they were unrealized, you’d only have to pay 80 cents to make up the difference.
The Problems With an Unrealized Capital Gains Tax
Now that we’ve looked at what a tax on unrealized capital gains could be like, it’s time to point out three significant reasons why any proposal to make this a reality probably won’t make it too far.
1. A new unrealized capital gains tax would be a headache to enforce.
For a tax like this to work, thousands of taxpayers would need to evaluate the value of all of their assets every single year. That raises the question: How in the world would the IRS—which is already understaffed and overburdened as it is—be able to audit all those filings?3
Sure, investments like stocks and mutual funds are simple because they have a set market price. But things get a lot squishier when we start talking about things like rental properties and businesses, which are the main source of wealth for many high-net-worth individuals. Those types of assets are much harder to put a price tag on. And we haven’t even talked about collectibles, jewelry and other nonliquid assets that are also part of your net worth. (If you’re curious, you can use our net worth calculator to help you figure out what your net worth is!)
Plus, some folks won’t have the cash on hand to pay the millions of dollars in taxes they might owe on the unrealized gains of their assets, which would force them to sell some of those assets in order to pay the tax bill. And what happens if those assets lose value in another year? Will they be entitled to a refund from the federal government?
That’s one of the many reasons why so many European countries have abandoned similar taxes—the administrative headaches just aren’t worth it.
2. The proposed tax probably doesn’t have enough support in Congress.
This isn’t the first time that lawmakers in Washington have tried to pass a similar type of “wealth tax”—and these proposals have hit a brick wall every time. It doesn’t look like this one is any different.
It’s important to remember, Congress treats the release of the budget from the White House more like a list of suggestions than something that’s written in stone. In reality, Republicans are unlikely to get on board with any tax on unrealized gains, while a handful of Democrats have already come out and said they won’t support it—or have at least cast doubts on whether it’s a practical idea to begin with.4,5
That could be enough to sink this latest attempt to pass a wealth tax before it ever leaves the harbor.
3. A tax on unrealized capital gains might be unconstitutional.
And then there’s the question of whether it’s even legal to tax unrealized capital gains. You see, the Constitution makes it extremely tough for the government to impose direct taxes. In fact, Congress had to pass a constitutional amendment just to put a federal income tax in place.6
Without diving too much into the legal mumbo jumbo, that basically means any tax that is passed must be spread evenly among every person in every state. And a tax on unrealized capital gains could be considered a direct tax because it’s a tax on the personal property of a select group of people.
Legal experts and politicians can debate the issue all they want, but it’s almost a sure bet that if Congress passed a tax on unrealized capital gains, lawsuits would follow right away. It’s likely the Supreme Court will ultimately decide on the issue—and it’s very possible that they’ll strike it down.
Talk With a Tax Pro
Realized or unrealized, trying to figure out capital gains taxes (or any kind of taxes, really) is difficult enough without the politicians getting involved. That’s why you should always work with a qualified tax pro, like one of the pros in our tax Endorsed Local Providers (ELP) program.
Whether you’re managing hundreds of thousands or even millions of dollars’ worth of investments, our RamseyTrusted pros can help you get your taxes done right. One mistake or oversight on your tax return could put you in hot water with the IRS—and that’s just not worth the headache.