Unrealized Capital Gains are Not Part of Income

Just imagine that you paid $1,000 to purchase a stock this year and on December 31, 2021, it is valued as $2,000 based on then current stock prices (i.e., fair market value). Under the present law, you would not be taxed on the $1,000 increase in value unless you sold the stock, a taxable event. The Democrats in Congress are making the case that the revenue component of the Build Back Better legislation authored by Chair Richard Neal (D-MA) and approved by the Ways and Means Committee on September 15 is a long-awaited first step toward fixing a fundamentally flawed and inequitable tax code. What this means is the $1,000 increase in value would be taxed even though it is an unrealized capital gain, that is, no sale has occurred.

The taxation on unrealized capital gains is expected to affect people with $1 billion in assets or $100 million in income for three consecutive years. “We probably will have a wealth tax,” House Speaker Nancy Pelosi (D., Calif.) said Sunday on CNN, noting that Senate Democrats were still working on their proposal, which isn’t technically a wealth tax but bears a strong resemblance to that idea. The proposal under consideration from Senate Finance Committee Chairman Ron Wyden (D., Ore.) would impose an annual tax on unrealized capital gains on liquid assets held by billionaires, Treasury Secretary Janet Yellen said Sunday on CNN.

Let’s be clear that unrealized capital gains are not income. Yes, they increase wealth and that’s why calling it a wealth tax is more palatable to some. Still, how can Congress tax an event that does not (i.e., the sale) trigger a tax liability through a completed transaction? Yes, it becomes part of one’s estate but should not be taxed until the death of the taxpayer, as presently is the case.

Another problem with taxing unrealized capital gains is what to do if the value of the capital asset goes down in subsequent years. Say, for example, in the second year the $2,000 market value declines to $1,500. Should the government allow the taxpayer to recover the “income” in the previous year of $500 ($2,000-$1,500) as a loss in the current year and provide a tax deduction in that year. The current proposal to further tax the rich introduces an element of unfairness especially if tax losses are not treated like tax gains –they are both taxable events.

I support much of what is in the Build Back Better legislation as scaled back that seems headed for approval later this week except for the tax on unrealized capital gains. It’s true that this portion of the bill raises more than $2 trillion in a highly progressive way to fund essential investments in a stronger and more inclusive economy. Still, the unrealized gain and loss provision of the bill should be fairly applied with respect to gains and losses. Moreover, including a provision whose motivation is to pay for spending in the legislation, not out of fairness, is unethical. Saying it is a wealth tax is disingenuous. 

To better understand my point of view, consider that you run your own business and earn $10,000 in one year. Should you be taxed on the net income in Schedule C? Yes, because it’s earned income. But what if you lose $1,000 say in your first year. Should you be able to deduct it from adjusted gross income? The answer is YES. Where is the fairness in comparison to unrealized capital gains and losses unless both are taxed? Moreover, how can you have more money in your pocket if you haven't sold the stock investment and may hold on to it for many years?

It's important to understand that Title 26 of the United States Code (26 U.S.C.) does not include unrealized gains on capital assets as part of income. Here is what the tax code says:

26 U.S. Code § 61 - Gross income defined

(a) General definition. Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items.

(1) Compensation for services, including fees, commissions, fringe benefits, and similar items.

(2) Gross income derived from business.

(3) Gains derived from dealings in property.

(4) Interest.

(5) Rents.

(6) Royalties.

(7) Dividends.

(8) Annuities.

(9) Income from life insurance and endowment contracts.

(10) Pensions.

(11) Income from discharge of indebtedness.

(12) Distributive share of partnership gross income.

(13) Income in respect of a decedent.

(14) Income from an interest in an estate or trust.

Some may say that item #3, Gross Income derived from dealings in property, refers to capital gains whether realized through a sale or unrealized because of market adjustments. However, the term “dealings” implies some action on the part of the holder of the capital asset, for example, by selling a stock investment.

Democrats are saying that the proposed new annual tax on billionaires’ unrealized capital gains is likely to be included to help pay for the vast social policy and climate package lawmakers hope to finalize this week. “We probably will have a wealth tax,” House Speaker Nancy Pelosi (D., Calif.) said Sunday on CNN, noting that Senate Democrats were still working on their proposal, which isn’t technically a wealth tax but bears a strong resemblance to that idea.

The proposal under consideration from Senate Finance Committee Chairman Ron Wyden (D., Ore.) would impose an annual tax on unrealized capital gains on liquid assets held by billionaires, Treasury Secretary Janet Yellen said Sunday on CNN. “I wouldn’t call that a wealth tax, but it would help get at capital gains, which are an extraordinarily large part of the incomes of the wealthiest individuals and right now escape taxation until they’re realized,” Ms. Yellen said.

This may be true but can be better accomplished by raising the top tax on capital gains to the same rate taxed on any other form of income of an individual (39-6 percent in the proposed bill) or from 20 percent, the current tax rate on capital gains, to 25 percent, the proposed rate on capital gains in the proposed bill.

Groups such as the National Taxpayers Union have objected to the tax on billionaires’ unrealized capital gains, saying it would add more bureaucracy to the tax system and impose new burdens on business investors.

What is the real motivation to pass a tax on unrealized gains? I think it is because Democrats have been scrambling to find new ways to pay for the Build Back Better package’s roughly $2 trillion in spending after key centrist Sen. Kyrsten Sinema (D., Ariz.) signaled her opposition to increasing the marginal tax rates on corporations, capital gains or individuals.

When compared with the tax-rate increases in the House bill, the emerging Wyden proposal would be significantly more progressive, in that it would raise its money from the very, very rich—likely fewer than 1,000 taxpayers—instead of the merely rich. But House Democrats have questioned whether it makes sense to add a relatively untested idea at this late stage. If they question its validity now, then in fairness to all it should not be part of the final legislation.

Posted by Dr. Steven Mintz, The Ethics Sage, on October 26, 2021. Steve is the author of Beyond Happiness and Meaning: Transforming Your Life Through Ethical Behavior. You can sign up for his newsletter and learn more about his activities at: https://www.stevenmintzethics.com/. Follow him on Facebook at: https://www.facebook.com/StevenMintzEthics and on Twitter at: https://twitter.com/ethicssage.