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Preparing for the Unknown: What a Capital Gains Rate Hike Could Mean
Tuesday, May 11, 2021

Although it is unclear what will happen to capital gains rates over the course of the next year, it is important to discuss the implications of what a rate hike could mean. We don’t know for certain whether the capital gains rate will be adjusted, what rate would apply if it were or when it would be effective.

Below we discuss planning ideas that are available to those who fall into the following categories: (1) taxpayers expecting to recognize capital gains in the short term (e.g., sales of company interests or asset deals, real estate sales in 2021), (2) taxpayers who expect to recognize capital gains in the medium term (e.g., gains in 2022 and beyond) and (3) taxpayers who have realized gains but deferred them (e.g., taxpayers who are recognizing gains under an installment sale or investment in Qualified Opportunity Funds).



Generally, those who expect to generate capital gains in the next few months will likely want to ensure they are paying tax at no greater than the current long-term capital gain rate of up to 20% US federal tax, plus applicable 3.8% Medicare tax and applicable state and local tax. Thus, those thinking of selling should move with relative speed to close the transaction. Additionally, taxpayers will likely want to avoid entering short-term gain recognition deferral transactions, such as installment sales and investments in Qualified Opportunity Funds because they would defer the tax today in order to pay the tax in the future at what could be a significantly higher rate. On the other hand, long-term deferral strategies such as section 1031 exchanges are still appropriate because the deferral can last indefinitely. Taxpayers should confirm whether the tax exclusion benefits of Code Section 1202 Qualified Small Business stock may apply to the sale (see below for a larger discussion on this topic).


Taxpayers in this category will fall into two groups. The first is those who may wish to accelerate capital gains depending on whether they are confident a capital gain recognition event will happen sometime in the near term (but after a rate hike has occurred) and the approximate amount of the sales price is disclosed. Of course, both of these factors are highly speculative but the prospect of higher rates will become clearer in the coming weeks.

The second group consists of those who may wish to take the wait-and-see approach, in which case they may simply have a gain recognition when the rates have increased or hope to hold onto an asset until death with the expectation of a basis step up. In this scenario, they will likely want to use tax deferral techniques.


Gains on publicly traded securities can be accelerated through properly separated market sales and purchases as there is no statutory prohibition on wash gain transactions, in contrast to the wash sales rules for losses. Gain may also be accelerated through the use of certain derivative transactions resulting in a deemed sale without actually exiting the position. For example, certain derivative transactions (i.e., short sales, short swaps, forward sales agreements or option collars with a narrow band) that are treated as constructive sales for US federal tax purposes under Code Section 1259 can be entered. Securities lending transactions that purposely fail to meet the requirements for tax-free treatment under Code Section 1058 provide an alternative that could allow a client to accelerate gains and diversify holdings. Utilizing these derivative techniques is likely more readily available to owners of publicly traded securities, though it is possible to accelerate gains on closely held assets through related party sales transactions as there is no section 267 equivalent for gains on sales to related parties. Another possibility for closely held shares is to purposely fail one of the tax-free code provisions for the transfer of assets. For example, an asset may be transferred to a Type C or Type S corporation in a manner that would fail to meet the requirements to qualify as a tax-free Code Section 351 transaction. Moreover, a sale of assets to a non-grantor trust may accomplish two goals – gain acceleration and estate planning.

Finally, a sale to an employee stock ownership plan (ESOP) is a method that could accelerate gains when a shareholder sells stock of a Type C or Type S corporation that also serves as a method to create an employee benefits plan. In certain scenarios, gains from this type of sale could be deferred if the proceeds are invested appropriately, according to the terms of Code Section 1042.

The converse to accelerating gains is deferring losses. Losses are more valuable when rates are higher. Thus, taxpayers could delay selling loss assets until the year in which they expect higher tax rate capital gains to occur.


An alternative and important method to reduce tax on capital gains is through the application of the Code Section 1202 Qualified Small Business Stock exclusion, which allows gains on the sale of stock equal to the greater of 10 times the taxpayer’s basis in stock or $10 million to be excluded from US federal income tax. For example, if a client invested $10 million in a corporation, the client could sell the company for up to $110 million with zero US federal income tax liability owed. Clients can maximize the benefit of these rules, and even receive better results, by converting an entity treated as partnership to a C corporation. Converting an entity to C corporation would require a five-year waiting period before the benefits are applicable. Moreover, the tax benefits apply on a per shareholder basis, so a taxpayer could gift stock interests to trusts or children to multiply the benefits of this exclusion.

Moreover, charitable giving can be used to reduce tax liability. In this respect, charitable remainder trusts, charitable lead trusts and other techniques may be utilized that can result in significant tax savings.

With respect deferral, one of the most discussed technique at the moment is investments in qualified opportunity funds. This investment would provide a taxpayer with two benefits. First, the client would defer tax on capital gain until December 31, 2026 (a time at which the rates may have been reduced from whatever rate US President Joe Biden is able to increase them to), and more importantly, the new investment can be sold after a 10-year holding period and is subject to zero US federal income tax regardless of the amount of gains recognized. For example, a client could invest $1 million in a tech start-up that sells 10 years later for $100 million and pay no tax on the $99 million of appreciation. There are significant requirements that need to be followed in order for such an investment to qualify.

An alternative deferral technique is the installment sale. An installment sale allows taxpayers to recognize the gain from a sale ratably over the term of years that payments are to be made. In certain instances, it may be useful to utilize a deferred sales trust (DST) or other intermediary that could assist with facilitating an installment sale.


Taxpayers could have entered deferral transactions that they now realize may be tax inefficient. Meaning, they did not expect to defer taxes into a year when the rates were significantly higher. A taxpayer who entered an installment sale may now want to accelerate the gain on the sale so that future payments would not be subject to the higher rates. One possible way to address this issue is to renegotiate the terms of the installment sale, with the buyer and seller agreeing to revise the timing (and potentially amount) of the remaining deferred payments. Alternatively, an installment sale gain can potentially be accelerated by borrowing cash and pledging the installment note as collateral.

Similarly, a number of taxpayers entered qualified opportunity fund investments and have sought to accelerate the deferred gains associated with the investment. A solution is available. If done properly, it is possible to accelerate the deferred gains while retaining the other benefits of investing in a qualified opportunity fund.

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