Mark-to-Market Taxation of Capital Gains

Mark-to-Market Taxation of Capital Gains

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Updated March 29, 2022
Mark-to-Market Taxation of Capital Gains
Capital gains are subject to tax only when realized upon
a 25% ceiling. Gain on collectibles is taxed at 28%. The
sale of an asset. The tax does not apply to gain on assets
law excludes $500,000 for a married couple and $250,000
passed on at death, due to tax rules that apply to capital
for a single person from gain on home sales.
gains realized by heirs. This exclusion from the tax base
limits the taxes, in particular, that can be imposed on high-
Capital gains are taxed only if the asset is sold and not as
income taxpayers who hold most of the assets that yield
gains accrue. This treatment allows the tax to be deferred. If
capital gains. Senator Wyden, chairman of the Finance
the asset is passed on to heirs at death, any capital gain
Committee, has proposed to tax gains realized by high-
escapes tax because the basis to the heirs is the market
income taxpayers on an accrual basis (i.e., regardless of
value at the time of death, referred to as stepped-up basis. If
whether the asset is sold), a method called mark-to-market.
an heir were to sell an appreciated asset immediately, no tax
President Biden’s budget proposal includes a 20%
would be due.
minimum tax on income plus unrealized capital gains on
those with wealth of $100 million or more. Because the
Concentration of Gains in High Incomes
minimum tax payment would be the minimum tax minus
Capital gains are largely realized by high-income taxpayers.
regular tax, the additional tax would largely arise from
Table 1 indicates that the top 10% of taxpayers by income
mark-to-market treatment of gains.
were responsible for almost three-quarters of capital gains
but only a quarter of income. The top 0.001% of taxpayers
What Are Capital Gains?
(representing fewer than 1,500 returns) were responsible for
Capital gains are the increase in the value of an asset, such
about 15% of capital gains and 2% of income.
as corporate stock, land, a building, or the increase in the
value of a business. The gain is the difference between the
Table 1. Distribution of Capital Gains (Income
market value and the basis. For a corporate stock, the basis
Amounts in Millions of Dollars), 2017
is the price paid for the stock when acquired. For a physical
asset such as a building, the gain is the cost of acquiring or
Share of
constructing the building plus the cost of any subsequent
Adjusted
Share of
capital improvements minus depreciation taken on the
Income
Average
Gross
Capital
original building or any capital improvements.
Percentile
Income
Income
Gains
The Capital Gains Tax
0.001
178.8
2.3
14.6
Assets yielding capital gains benefit from (1) deferral of tax
0.01
39.5
5.2
29.8
until gains are realized, (2) a lower rate if held for a year or
0.1
8.0
10.5
48.6
more, and (3) exclusion of gain at death. As with other
elements of the tax code measuring capital income, gains
1.0
1.6
21.0
68.2
are not adjusted for inflation.
10.0
0.4
26.4
74.4
Short-term gains, on assets held for less than a year, are
Source: Internal Revenue Service, Statistics of Income, Individual
taxed at ordinary rates of up to 37%. Long-term gains, on
Statistical Tables by Tax Rate and Income Percentile, Table 3,
assets held for at least a year, are taxed at up to 20%. The
https://www.irs.gov/statistics/soi-tax-stats-individual-statistical-tables-
lower rates are tied to the permanent tax brackets (ordinary
by-tax-rate-and-income-percentile.
tax rates are temporarily lower through 2025). For 2021, no
tax is due for returns with taxable income below $80,800
For the top 0.001% of taxpayers by income, capital gains
for married couples ($40,400 for singles). For married
accounted for 56.4% of income and wages less than 8.7%.
couples with income below $501,000 ($445,580 for
For the top 10%, capital gains accounted for 16.8% of
singles), the long-term capital gains tax rate is 15%. For
income and wages accounted for 55.4%.
taxpayers with higher incomes, the tax is 20%. For married
taxpayers with income above $250,000 ($200,000 for
Survey of Consumer Finances data indicate that unrealized
singles), capital gains, along with other types of passive
gains are also concentrated on higher-income individuals,
capital income, are subject to an additional 3.8% net
although that survey excludes the wealthiest individuals.
investment income tax. (This rate equals the Medicare A
Overall unrealized gain is estimated to be approximately
tax imposed on earnings.)
equal to realized gain, or about 50% of total accrued gain.
Unrealized gain may be an even higher share for wealthy
Certain types of capital gains have special rules. Gain from
families that are the founders of successful corporations and
depreciation of assets is subject to ordinary rates, although
retain shares to maintain control.
gain arising from depreciation of real property is subject to
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Mark-to-Market Taxation of Capital Gains
Mark-to-Market Proposals
A final issue is whether to index gains for inflation, if the
A mark-to-market proposal would measure gain each year
ability to defer and possibly eliminate tax on unrealized
based on market value and thus would include not only
capital gains occurs under mark-to-market. A case against
realized gains but also unrealized gains. The recognized
this treatment could be made based on rate differentials and
gain would be added to the basis for measuring future gain.
the allowance of nominal interest deductions for borrowing
Most proposals would limit this treatment to high-income
to finance assets that yield capital gains. Deducting interest
taxpayers, in part to avoid compliance and administration
based on rates that reflect inflation and taxing only the real
problems for other taxpayers. The Wyden proposal would
part of gains would lead to tax arbitrage.
apply this regime to taxpayers with either $1 billion of
assets or $100 million of earnings over the past three years,
Issues in a Mark-to-Market Regime
affecting approximately 700 taxpayers (so-called
One of the benefits of mark-to-market taxation is that it
billionaires). Taxpayers would stay in this regime, until
would permit higher tax rates on capital gains, likely
they fell to half of both thresholds for three years. The
without inducing behavioral responses. Some part of the
Biden proposal would apply to taxpayers with $100 million
revenue gain from raising taxes on realized capital gains is
or more in wealth.
lost because it increases the lock-in effect, as individuals
reduce their realizations as a result of higher taxes. There is
One of the challenges of a mark-to-market proposal would
a considerable range in the estimates of the magnitude of
be in the treatment of assets that are not publicly traded,
this effect (see CRS Report R41364, Capital Gains Tax
such as real estate, land, and private businesses. Tax data
Options: Behavioral Responses and Revenues, by Jane G.
suggest these assets account for about a third of capital
Gravelle for a review). For taxpayers subject to accrual
gains realized.
methods, rates could be raised without a loss of revenue
from the lock-in effect.
Excluding non-traded assets would encourage investments
in forms not subject to tax. It is possible to apply a look-
A mark-to-market regime would also increase the
back method or interest charge that would account for the
progressivity of the tax system by increasing the amount of
value of deferring the tax. To complete the equating of tax
income subject to tax for high-income taxpayers. Some of
on these assets, gains would be taxed at death or subject to
these taxpayers pay a small effective tax rate on their
a carry-over of the original basis. (See CRS In Focus
economic income. A White House study, released on
IF11812, Tax Treatment of Capital Gains at Death, by Jane
September 23, 2021, estimated that the Forbes 400 paid an
G. Gravelle for a discussion of these approaches to
effective tax rate of 8.2% for the period 2010-2018 on
addressing the step-up in basis that leads to the exclusion of
income including unrealized gain.
gains.) Senator Wyden’s proposal would incorporate these
elements, using an interest charge method and treating
The revenue gain from a mark-to-market regime would
transfers by gift, death, or trusts as a taxable event. Spouses
depend on the income floor, the rates applied, and the
would be exempt but would retain the original basis of the
coverage of assets. Batchelder and Kamin estimated an $80
asset. President Biden’s proposal would require a valuation
billion revenue gain, if the top 0.1% of taxpayers were
of nontradeable assets but allow taxpayers with tradeable
covered and the income taxed at ordinary rates. The Biden
assets that are less than 20% to defer tax on nontradeable
proposal is estimated to gain about $40 billion.
assets with an interest charge.
Two concerns about mark-to-market are (1) costs of
There are also issues about whether to grandfather existing
administration and compliance and (2) liquidity. These
unrealized gains; if so, those gains would be recognized
issues are less important if mark-to-market is confined to
only if and when assets are sold. Senator Wyden’s proposal
tradeable assets and high-income individuals, who have the
would include existing gains over a five-year period, and
resources to comply with the new regime and access to
President Biden’s proposal would allow an initial nine-year
other income or borrowing as well as selling shares to pay
installment period for paying the tax.
the tax.
Another issue is how to treat accrued losses. Net capital
Alternatives to Mark-to-Market
losses are restricted to reducing ordinary income of $3,000
One alternative is to change the treatment of capital gains at
and unused losses are carried forward. Loss limits may be
death by taxing capital gains at death or imposing carry-
considered appropriate in light of the tax rate differentials
over basis so that heirs would take as their basis the basis of
on ordinary income and capital gains and the discretion
the decedent rather than market value. Both approaches
individuals have over realizations. Accrual taxation
could be designed to apply only to high-income taxpayers.
eliminates the latter concern. One option would be to allow
See CRS In Focus IF11812, Tax Treatment of Capital
losses in proportion in the tax rate differentials. For
Gains at Death, by Jane G. Gravelle for a discussion of
example, if the capital gains tax rate is 20% and the
these approaches. Another alternative is to increase the
ordinary rate is 37%, each dollar of net loss could offset 54
corporate tax rate.
cents (0.20/0.37) of income. The Wyden proposal would
allow a three-year carry-back of losses against gains taxed
Jane G. Gravelle, Senior Specialist in Economic Policy
due to mark-to-market. Because the Biden proposal is a
minimum tax, accrued losses mean the tax does not apply.
IF11957

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Mark-to-Market Taxation of Capital Gains

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https://crsreports.congress.gov | IF11957 · VERSION 3 · UPDATED