Are We Ready to Pay Taxes?

January 2022 marks a new tax environment for Washington State residents. For the first time ever, we may have a state tax filing requirement. In 2021, the Washington State Legislature approved a 7% tax for capital gains over $250,000.

History of the tax

Washington state revenues have historically been raised via the imposition of a state sales tax. Since lower-income residents may spend more of their income buying necessities, this type of system is seen by some as a regressive tax system. Regressive is defined as one in which those with higher income pay less in proportional taxes. Governor Inslee has long advocated for a capital gains tax to primarily tax tech-sector employees who receive stock grants as part of their compensation.

There are several issues with this tax. First, it is deeply unpopular. In the recent advisory vote, 61% of voters said that the legislature should not maintain the tax. Advisory votes are rather confusing and unique to Washington. In 2012, a bill was passed requiring all legislative tax and fee increases be added to the ballot. This was to allow voters to voice their approval, or disapproval. The advisory vote is in no way binding on the legislature, though many politicians use the vote to direct their legislative priorities. This means the advisory vote has no impact on the law, and the capital gains tax will go into effect on January 1.

Second, the Washington State Constitution prohibits the imposition of an income tax. Two court challenges have been filed stating this capital gains tax is a disguised income tax and as such, should be declared unconstitutional. At the federal level, capital gains are reported on the personal income tax return. However, capital gains receive different tax treatment compared to ordinary income and are not includable as taxable wages for Social Security and Medicare taxes. The court decisions will likely influence both sides in how they construct future tax legislation.

Specifics of the tax

What is a capital gain? It is the increase in price between the purchase and sale date of an asset. Currently there are some very large exemptions from this tax. Gains from directly-owned real estate, retirement accounts and certain business assets are excluded. Special exclusions are also available to farming, fishing, timber and auto industries. This essentially means that gains on stock and personal property (e.g., cars, art, collectibles) will be subject to the new 7% tax.

To calculate this tax, there are specific steps to follow. The first is to calculate all taxable gains. Second, reduce the gain by the $250,000 exclusion. Note that this exclusion is $250,000 for an individual and $250,000 for a married couple. You cannot file “married filing jointly” for your federal return and then file separate returns to receive two exclusions.

There is one potential deduction for taxpayers who make charitable donations over $250,000. They will be able to deduct the charitable donations over that amount, to a maximum of $100,000, from their capital gains tax. To put it more simply here is an example:

A taxpayer has $375,000 of eligible capital gains and $275,000 of charitable contributions during 2022. The capital gain exclusion reduces the potential taxable gain to $125,000 ($375,000 – $250,000 exclusion). The charitable deduction is $25,000 ($275,000 – $250,000 exclusion). This makes the taxable gain $100,000 and will be taxed at 7%. The tax is due alongside the federal filing deadline, typically on April 15, unless an extension is requested. Note that an extension of time to file does not extend the payment due date, the first of which is April 17, 2023.

Planning for the tax

Traditionally, relatively few taxpayers have $250,000 in capital gains in a single year. This is especially true since the gain on the sale of your home is excluded. If you expect to be subject to the tax, there are several things you should do.

The first is to consult with your tax professional to understand the tax liability you will incur. The second is to consider planning sales over a longer period, systematically taking gains on an annual basis to keep the total gains under the $250,000 threshold. This will reduce the impact of this new tax.

Another option is to do nothing. This would appropriate for those who believe that the courts will strike down the law or that the legislature will listen to the advisory vote and repeal the tax. Both are possible outcomes. However, as the legislature continues to look for income, it is likely that new sources of tax revenue will be explored. Thoughtful tax planning is important to maximize the value of your assets. At Ferguson Wellman and West Bearing, we like to say, “It’s not about what you earn, it’s about what you keep.”

Chris Bixby is a Senior Vice President with Ferguson Wellman

Portfolio and Wealth Management. Ferguson Wellman is a 47-year-old registered investment adviser serving multigenerational families and nonprofits. The firm manages $8.2 billion for 913 clients with assets starting at $4 million. Its division, West Bearing Investments, has a minimum of $1 million. More than $1 billion of the firm’s assets are managed for clients residing in Washington. (Data as of 12/31/2021)

Ferguson Wellman, Octavia Group and West Bearing do not provide tax, legal, insurance or medical advice. This material has been prepared for general educational and informational purposes only and not as a substitute for qualified counsel. You should consult qualified professionals to understand how this information may, or may not, apply specifically to you.

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