By Pete Mooney
This piece is a little off topic for typical Valley Reporter fare and it isn’t local news. But it is something that has been on my mind.
There has been a lot of talk recently about “taxing unrealized capital gains.” It is unclear to me what that really means and, on the surface, it would be very difficult to implement. I understand the desire to tax billionaires and other high net worth people with assets of greater than $100 million, but avoiding unintended consequences is critical and I don’t think the issue is the unrealized capital gains.
An unrealized capital gain is fairly easy to understand – if I bought a share of stock a year ago for 1 dollar and it is worth 2 dollars today, I would have a gain of one dollar if I sold it today. But until I actually sell it, that gain is conceptual and unrealized. The day after tomorrow, the value of the share could decline to $1.50 and the unrealized capital gain would be only 50 cents. The important point is that until the gain is actually realized it can vary from day-to-day, it is conceptual, and it isn’t taxed until the gain is realized.
To my mind, the real issue is how billionaires and high net worth individuals leverage this unrealized value tax free. I believe there are primarily two ways that they do this.
First, many of these individuals have taken advantage of the Roth IRA in a totally unintended way. The Roth IRA was a great idea designed to help people saving for retirement. Unlike a conventional IRA, it allows you to pay tax upon investment rather than when you withdraw funds. It made great sense if you thought taxes would be higher in the future or if you thought your future earnings would put you in a higher tax bracket. Billionaires found a loophole though. If I’m starting up a company, say my Silicon Valley Unicorn, I could take it public, own the bulk of the shares, and contribute them at very low value into a Roth account. My tax bill would be miniscule given the business was new and the value of the shares was not much. As the company became successful, the value of the shares would balloon. My vast fortune would be sheltered from further taxation since I already paid tax when I made the original investment.
The second issue is how to access cash based on the value of those tax-sheltered shares. Many financial institutions are more than willing to make loans to individuals using the value of shares as collateral. Billionaires and high net worth individuals can invest this cash in real estate and other money-making ventures. And can re-finance the loans as necessary. They basically use debt to finance their lavish lifestyles. Selling equity turns an unrealized capital gain into a realized one, but using debt is not a taxable event. In fact, if you can make the debt a business expense, the interest you have to pay, in some cases, may be tax deductible.
Just saying “tax unrealized capital gains” is a great tag line, but taken at face value it would be extremely difficult to implement, have many unintended consequences, and would set a very dangerous precedent.
For example, several questions that come to mind are: when do you value the unrealized capital gain for tax purposes, on April 15? What happens if that value drops significantly the next day? Do we blow up the Roth program to get at the tax-sheltered value and does that mean people get taxed twice on the same assets? Is the Redfin estimate on your home, compared to what you paid for it, an unrealized capital gain that will be subject to tax? I can see the lawsuits now.
It seems to me there are more subtle way to come at this. I’d like to think that whoever is working on tax policy around this topic is at least thinking at this level of detail. I would focus on the two points I have outlined. First, we should restrict the ability of individuals to use unrealized capital gains to collateralize loans. This could be focused on individuals with assets of greater than $100 million in a Roth IRA. Financial institutions would hate this – they earn a lot of interest on these loans, and high net worth individuals would hate it because they’d have to create taxable events to generate cash to fund their lavish lifestyles.
Second, I’d change the rules around Roth IRAs. I would set a limit on the appreciation of shares that would be exempt from future tax. In effect, the Roth could shelter a certain amount of value, but then it would revert to looking more like a conventional IRA. This would also address a generational wealth issue. Today, those Roth assets can pass on to one’s heirs without tax implications. Under this approach, at least some portion of the assets would be taxed just like mandatory distributions in a conventional IRA are.
Neither of these changes would likely impact us normal folks, but it would probably raise significant tax revenue from high-net-worth individuals. Also, I would like to think that neither of these ideas are beyond the grasp of the American electorate. The term “defund the police” was a tag line that had significant adverse consequences. It was not nuanced and it caused damage in its simplicity. Just look at what has happened to policing in Burlington and the resulting consequences. I would hate to see “tax unrealized capital gains” have the same lack of specificity and nuance. In general, we need to talk less in sound bites and dig more deeply into the root causes of issues.
Pete Mooney
Waitsfield
