As we described here, earlier this year the Washington Supreme Court ruled that the state’s capital gains tax is a constitutional excise tax, not an income tax, even though it is measured by net long-term capital gains allocable to Washington. Politicians and some press argued that the tax was easy to apply because the starting point was long-term capital gains reported on a taxpayer’s federal income tax return. However, because the statute was designed to mollify certain political constituencies, and to qualify as an excise tax instead of a tax on income, this tax statute is incredibly confusing and promises to open the door to much litigation.
Below, we break down the basics of what you need to know about this tax. Please appreciate, however, that this general guidance is by no means a substitute for thoughtful analysis of taxpayers’ individual situations.
Overview
- Effective January 1, 2022, Washington’s new capital gains tax applies a 7% tax on an individual’s adjusted long-term capital gains that are allocated to Washington.
- Tax only applies to individuals. Individuals are treated as “beneficial owners” of long-term capital assets held by a pass-through or other disregarded entities to the extent of the individual’s ownership in the entity.
- Tax only applies to long-term capital gains allocated to Washington state. The rules for allocating gains from the sale of tangible personal property to Washington are different than the rules for allocating capital gains from the sale of intangible personal property.
- Long-term capital gains and losses cannot be netted with short-term capital gains and losses.
What Are Washington Capital Gains?
Gains from the sale of Tangible Personal Property beneficiary or legally owned by the taxpayer are allocated to Washington in two scenarios:
- First Scenario:
- The tangible personal property was located in Washington at the time of sale.
- Second Scenario:
- Property was located in Washington at any time during the taxable year of sale OR the year preceding the year of sale; AND
- Taxpayer was a Washington resident at the time of sale; AND
- Taxpayer was not subject to income or excise tax on the long-term capital gains or losses by another taxing jurisdiction.
- Examples of tangible personal property include planes, artwork, cars, and yachts.
Capital gains from the sale of Intangible Personal Property beneficially or legally owned by an individual taxpayer are allocated to Washington if the taxpayer was domiciled in Washington at the time the sale or exchange occurred.
- Examples of intangible personal property include stock in corporations and intellectual property.
- NOTE: This section of the statute uses the term “domiciled” rather than the defined term “resident” for purposes of allocating the gain from the sale of intangible personal property. The statute uses the term “resident” in the provision applicable to the allocation of gain from the sale of tangible personal property.
Washington Residents, Place of Abode, and Domicile
The term “Resident” means:
- Any individual who was domiciled in Washington during the taxable year, unless the individual during the taxable year: (1) had no permanent place of abode in Washington, (2) maintained a permanent place of abode outside of Washington, and (3) spent less than 30 days in Washington; or
- Any individual who was not domiciled in Washington during the taxable year, but maintained a place of abode in Washington and was physically present in Washington for more than 183 days during the taxable year.
The term “Domicile” is not defined in the statute or regulations. For other legal purposes, domicile means the place where a person has physically lived, regards as home, and intends to return to even if currently residing elsewhere. For purposes of the capital gains tax, a person may be a Washington resident but not be a domiciliary of Washington. The term “domicile” is defined by reference to a person’s physical presence coupled with an intent (“domiciliary intent”) to live in or to return to such location indefinitely. In other jurisdictions, a person who is a domiciled in one state but then leaves that state to live elsewhere, will continue to be domiciled in the first state until the person establishes a domicile in a new state.
The term "Place of Abode” is not defined in the statute or regulations but generally refers to a home or place where the taxpayer may stay. It is possible to have many places of abode and to be a resident of more than one state but a person generally can have only one domicile.
Adjustments to “Washington Capital Gains”
To determine “Washington capital gains,” the taxpayer starts with their federal net long-term capital gain. Certain adjustments are made, primarily to remove capital gains and losses allocated to places outside of Washington.
Adjustments to determine Washington capital gains include:
- Adding any amount of long-term capital loss from a sale or exchange that is exempt from Washington’s Capital Gains Tax, to the extent such loss was included in calculating federal net long-term capital gain;
- Adding any amount of long-term capital loss from a sale or exchange that is not allocated to Washington to the extent such loss was included in calculating federal net long-term capital gain;
- Adding any amount of loss carryforward from a sale, or exchange that is not allocated to Washington, to the extent such loss was included in calculating federal net long-term capital gain;
- Subtracting any amount of long-term capital gain from a sale or exchange that is not allocated to Washington, to the extent such gain was included in calculating federal net long-term capital gain;
- And subtracting any amount of long-term capital gain from a sale or exchange that is exempt from the tax, to the extent such gain was included in calculating federal net long-term capital gain.
- Short-term capital gains and losses are excluded from the Washington capital gains calculation.
Deductions and Credits:
The taxpayer may deduct:
- The annual standard deduction of $250,000. The amount of the standard deduction is the same for an individual, a married couple, and domestic partners.
- The amount of adjusted capital gain derived from the sale or transfer of the taxpayer’s interest in a qualified family-owned small business.
- Charitable donations (subject to limitations).
- Donations must be to a charity that is principally directed or managed within the state of Washington.
- Only for donations over $250,000.
- Deduction is capped at $100,000.
Taxpayers are also allowed a credit against the tax equal to the amount of any income or excise tax paid by the taxpayer to another taxing jurisdiction on capital gains to the extent such capital gains are included in the taxpayer’s Washington capital gains. This credit applies to both tangible and intangible personal property located in the other tax jurisdiction.
Exemptions
Real Estate
- Gains from the sale of real estate are exempt from the Washington capital gains tax.
- Long-term gains and losses from the sale of interests in a privately held entity are exempt to the extent the gain is directly attributable to the real estate owned directly by such an entity.
- The allocable gain in this exemption is calculated by taking the fair market value of the real estate owned by the entity, less its basis, multiplied by the percentage of the ownership interest in the entity.
- NOTE: Real estate not directly owned by the entity in which the taxpayer is selling interests may be excluded from this exemption. Also, gain from the sale of a partnership interest that is subject to IRC section 751 special treatment (primarily gain from inventory and unrealized receivables) is excluded from this exemption.
- Fair market value of real estate may be established by a fair market appraisal of the real estate, by an IRC Section 1060 allocation by the buyer and seller or by assessed value. In each instance, the statute specifically states that the Department is not bound by the taxpayer’s determination of value.
Miscellaneous Exemptions
- Retirement Accounts (401ks, IRAs, Roth IRAs, Retirement Annuities, etc.)
- Assets under imminent threat of condemnation proceedings;
- Cattle, horses, or breeding livestock;
- Gains from depreciable property under IRC Sec. 167 or property that qualifies for expensing under IRC Sec. 179;
- Timber and timberland, including dividends or distributions from REITs derived from gains from the sale or exchange of timber and timberland;
- Commercial fishing privileges; and
- Goodwill received from the sale of an auto dealership.
Discussion Points
- Rules for real estate owned by lower-tiered entities in multi-tiered entity structures.
- Statute authorizes Department to ignore selling price of real estate when determining fair market value.
- Exemption for sale of horses only applicable to taxpayers who receive more than 50% of gross income for the taxable year from farming or ranching. Gains from sale of hobby horses will be included in the tax.
- The statute applies to capital gains from property owned by revocable trusts and other “grantor trusts” (trusts in which the trustor of the trust and in some cases a trust beneficiary is treated for income tax purposes as the “owner” of the trust assets).
- The statute does not apply to irrevocable Washington trusts that are not grantor trusts.
- The statute also does not apply to estates or to revocable trusts that become irrevocable after the death of the grantor.
- In certain circumstances, for federal income tax purposes gains and losses from the sale of long-term capital assets sold by an estate or non-grantor trust may be carried out to the estate or trust beneficiaries as part of their federal long-term capital gains.
Planning Considerations
Limited Qualified Family-Owned Business Deduction
A taxpayer may deduct from their Washington capital gains the amount of gain derived from the sale of substantially all of the fair market value of the assets of, or the transfer of substantially all of the taxpayer’s interest in, a qualified family-owned small business.
- Taxpayer must have held a qualifying interest for at least five years immediately preceding the sale.
- Taxpayer or their family must have materially participated in operating the business for at least five of the 10 years immediately preceding the sale, unless it was a sale or transfer to a qualified heir.
- Business must have had worldwide gross revenue of $10M or less in the 12-month period immediately preceding the sale or transfer.
- Generally, 50% of the business must be owned, directly or indirectly, by any combination of the taxpayer or members of the taxpayer’s family, or both.
Qualified Small Business Stock
IRC Section 1202 allows exclusion of gain (up to $10M or 10x the taxpayer’s tax basis) for sales of “Qualified Small Business Stock” (“QSBS”), assuming certain holding periods and other requirements are met.
Because the starting point of the Washington capital gains tax is the federal long-term capital gains reported on a taxpayer’s federal return, Washington implicitly allows this exclusion.
IRC 1245
IRC Sec. 1245 requires taxpayers to characterize gain on the disposition of certain IRC Sec. 1231 property as ordinary income to the extent of previously taken depreciation deductions.
Such property includes depreciable and tangible personal property (furniture and equipment) and other intangible personal property (patents and licenses) that are amortized over time.
Because the starting point of the Washington capital gains tax is federal long-term capital gains, Washington implicitly recognizes IRC 1245 treatment. Thus, depreciation recapture amounts should escape the Washington capital gains tax to the extent such amounts are treated as ordinary income for federal income tax purposes.
Installment Sales
If a taxpayer reports payments for a sale on the installment method for federal tax purposes, they will report the long-term gain the same way for Washington’s capital gains tax. In other words, capital gains tax will be owed as the payments are received.
If the original sale took place before the effective date of January 1, 2022, the taxpayer should not owe Washington capital gains tax on any of the payments received. On the other hand, if the sale occurred after that date the taxpayer may owe the Washington capital gains tax even if they are no longer a Washington resident or domiciliary.
Trusts and Pass Through Entities
The Washington capital gains tax applies only to the sale or exchange of long-term capital assets legally or beneficially owned by an individual.
An individual is treated as the beneficial owner of the long-term capital assets held by “pass through” or “disregarded” entities for federal tax purposes. Consequently, when such an entity sells a long-term capital asset, any Washington owner will be treated as a proportional seller of such asset to the extent of the owner’s interest.
- NOTE: This section of the statute does not refer to the “direct ownership” of assets by an entity as it does in connection with the exclusion for gain from the sale of an interest in an entity that owns real estate. This omission suggests that the gain from assets held through multiple tiers of pass-through and/or disregarded entities may be deemed to be beneficially owned by the individual owners of such entities.
The statute includes a specific rule for irrevocable trusts to which the grantor’s contribution of assets are treated as incomplete gifts for federal gift tax purposes. These types of trusts are referred to as incomplete non-grantor trusts or “INGs” The most common planning purpose for an ING trust is to create an irrevocable trust, with a contribution that is not treated as a taxable gift, in a state that does not impose an income tax. This is done by making the gift “incomplete” for gift tax purposes. This rule does not prevent a taxpayer from creating a non-grantor irrevocable trust in Washington or another state by way of a taxable gift.
Administrative Considerations
Filing Procedures
- Individuals that owe capital gains tax are required to file a return, along with a copy of their federal tax return for the same taxable year.
- The return is due at the same time as the individual’s federal income tax return.
- That means those who receive a filing extension for their federal income tax return receive the same extension for the capital gains tax return. However, it does not extend the due date for paying the capital gains tax.
- Those that only have exempt capital gains or less than $250,000 in capital gains allocated to the state do not need to file a return.
- Unless an exception is obtained, the tax must be paid electronically via SAW through “My DOR” or via ACH bank transfer. See DOR Electronic Payment Guide.
Penalties
- Failure to file a return, along with a copy of the taxpayer’s federal income tax return, results in a penalty ranging from 5% - 25%, depending on how long the return remains unfiled.
- NOTE: The Department MUST cancel this penalty if failure to file the return is due to circumstances beyond the taxpayer’s control OR the taxpayer has not been delinquent in filing any return due during the preceding five calendar years.
- Any attempt to knowingly evade payment of the tax results in a class C felony as provided in chapter 9A.20 RCW.
- Any taxpayer who knowingly fails to pay the tax, make returns, keep records, or supply information, is guilty of a gross misdemeanor as provided in chapter 9A.20 RCW.
References
This article is a summary of some of the key points regarding the new Washington capital gains tax and not intended as legal advice. Lane Powell’s team of tax attorneys is here to answer your questions. For more information, contact Aimee Miller (millera@lanepowell.com; 206.223.7098), Lewis M. Horowitz (horowitzl@lanepowell.com; 206.223.7401), or Gary Kirk (kirkg@lanepowell.com; 206.223.6001).