Understanding Unrealized Capital Gains and Their Importance
To begin with, there are three primary forms of income: earned income, passive or unearned income, and investment income. Earned income includes wages, salaries, tips, and commissions, and it is taxed progressively by the IRS, meaning higher earnings fall into higher tax brackets, with the top federal bracket reaching 37%. Passive income, which can come from sources such as rental properties, royalties, or limited partnerships, is generally taxed at the same rates as earned income.
Investment income, however, is distinct in its treatment. It includes interest, dividends, and capital gains on investments. Capital gains are taxed in two different ways: short-term capital gains (for assets held less than twelve months) are taxed as ordinary income, while long-term capital gains (for assets held longer than twelve months) are taxed at fixed rates of 0%, 15%, or 20%, depending on the investor’s income for the year. A realized capital gain occurs when an appreciated asset is sold for profit. On the other hand, an unrealized capital gain is when the asset’s value increases, but the asset is not sold, meaning the gain exists only “on paper.”
Now, why is this important? The topic has gained attention because President Biden has proposed taxing unrealized capital gains. To illustrate, imagine you purchase 500 shares of Chewy (CHWY) stock at $26.00 per share in June 2024, and by December 2024, the stock price rises to $30.00 per share. On paper, you have gained $2,000. However, since you haven’t sold the stock, you don’t have this $2,000 in your bank account; it remains an unrealized gain. Under Biden’s proposal, you would be required to pay taxes on this $2,000, even though you still own the shares.
This proposal raises several concerns. For example, consider the complexity of valuing assets like rental properties annually. Additionally, if the stock price drops back to $26.00 per share, how would the taxes paid on the unrealized gains be managed? Would you receive a refund? Also, if you lack the cash to pay the taxes by April, you might be forced to sell the stock. Since the stock was not held for a full year, the gains would be taxed as ordinary income, potentially at a higher rate. This policy could thus create challenges for investors and property owners, essentially functioning as a method for the government to increase tax revenue.