"NEW" WA Capital Gains Tax

Thursday, March 30, 2023

More than a year ago, the 2021 Washington State Legislature passed RCW 82.87 which creates a 7% tax on the sale or exchange of long-term capital assets such as stocks, bonds, business interests, or other investments and tangible assets.  The tax took effect on January 1, 2022, and the first payments are due on or before April 18^th, 2023.  Revenue collected from this tax is earmarked to cover educational costs in the state of Washington.

Why Are We Only Writing About it Now? 

Because on March 24^th of this year, the Washington Supreme Court ruled this tax was valid under the Washington State Constitution.  Prior to that, a lower court had ruled found it to be an “income” tax, which is unconstitutional in the state. However, the Washington Supreme Court overruled that decision, finding instead that it was a valid “excise” tax. 

This means that, for certain Washington capital gains incurred in 2022, taxpayers now have less than a month to report them and pay any tax due.  This rather discouraging news raises a lot of fairly urgent questions:  To whom does the tax apply, exactly?  To what sorts of gains?  Are there any exemptions from the tax?  This article will attempt to answer in a preliminary way some of these questions.  That said, we’re writing for general information only; we are not able to provide tax advice, and urge you to consult with your tax professional if there’s any chance this tax will apply to you.

How Does the Tax Work?

Beginning January 1^st, 2022, an excise tax of 7% is imposed on Washington taxable long term capital gains exceeding $250,000 and zero percent on gains under $250,000.  “Washington taxable capital gains” are determined by starting with gains reported on the individual’s federal income tax return.  An individual must pay tax on “intangible assets” (i.e. stocks, bonds, closely-held business interests) if the individual has his or her domicile in Washington. Gains on the sale of tangible assets are “Washington capital gains” if either (a) the property was located in Washington at the time of sale (whether or not the owner was a Washington resident or domiciliary at the time of sale) or (b) the owner was a Washington resident at the time of sale and the property had been in Washington within a year of the date of sale.

This tax only applies to individuals, not entities (i.e. corporations or partnerships) or some irrevocable trusts.  However, individuals can be liable for the tax because of their ownership interest in a pass-through or disregarded entity that sells or exchanges long-term capital assets.  Such disregarded entities include “grantor” trusts which includes trusts that are funded with “incomplete” gifts for tax purposes.  “Incomplete gift” is tax jargon; it often happens when a person creates an asset protection trust for himself or herself in certain states (i.e. not Washington or Oregon).

Several assets are exempted from this tax.  First, and mostly importantly, it does not apply generally to the sale or exchange of real estate although there are limitations if the real estate is owned through entities like LLCs.  It also doesn’t apply to sales or exchanges of retirement plan assets, sales from condemnation, depreciable property, timber or timberland, horses or other livestock, commercial fishing interests or goodwill from auto dealerships.

How Should Taxpayers Respond?

Now that the tax has been ruled constitutionally valid, the options are limited.  First and most importantly, talk with your tax professional quickly to determine if this tax applies to your 2022 income.  The capital gains tax return is due at the same time (April 18^th this year) as the individual's federal income tax return is due. Individuals who receive a filing extension for their federal income tax return are entitled to the same filing extension for their capital gains tax return. However, a filing extension does not extend the due date for paying the capital gains tax due.  Penalties will apply to late returns. Additional penalties and interest will apply to late payments.

Second, try to limit the gains on the sale of any asset not exempted from the tax to $250,000 per year.  This can be a challenge when trying to rebalance a stock or bond portfolio if held in a taxable account.  Given that market values on such assets are generally lower than they’ve been in some time, this may be a good year for clients living in Washington to sell appreciated stock or bond positions.  Also, try to engage in “loss harvesting” activities where possible to offset gains incurred in rebalancing. There is an important caveat to this though as short-term losses are not included in the calculation of federal net long-term capital gain and cannot be used to offset long-term capital gain subject to this “new” capital gains tax in Washington.

The news is a little better in the estate planning arena, since irrevocable trusts that aren’t characterized as “grantor trusts” are not subject to the tax.  Even this, however, has limited planning opportunities, because such trusts are subject to Federal income tax on long-term capital gains at rates that generally are higher than those for individuals.  As such, it may not be worth it to create an irrevocable trust for family members simply to avoid the new tax.

The “new” Washington capital gains tax certainly erodes Washington’s status as an income tax free state, no matter how the legislature characterizes it.  Clients should review their current and future plans with their advisors to determine ways to minimize the tax burden to the greatest extent possible.