The Washington Supreme Court recently upheld the constitutionality of the state capital gains tax (WA Cap Gains Tax) enacted in 2021. The new WA Cap Gains Tax creates new wrinkles and provides new planning opportunities for real estate plans for individuals.
This alert addresses the impact of the WA capital gains tax on estate planning for residents and non-residents of Washington. For a more general overview of the new law, which was upheld by the Washington Supreme Court on Friday, March 24, 2023, please see the linked advance alert. here.
From January 1, 2022, the WA Capital Gains Tax taxes “Washington capital gains”, i.e. net long-term federal capital gains for the taxpayer, subject to some adjustments. The tax is imposed on persons who are residents or residents of Washington. Everyone enjoys an annual exemption for the first $250,000 in capital gains in Washington, but gains over that amount are taxed at the 7% rate (plus any federal tax that may be due).
The WA capital gains tax generally applies to sales of financial assets, such as stocks and other securities, and tangible personal property held for investment. This standard does not apply to sales of real estate, privately owned entities that directly own real estate (to the extent the value of the entity is attributable to the real estate), and assets held in a 401(k), 403(b), or IRA.
In general, corporate entities are not subject to the WA Cap earnings tax. However, if a capital gain is realized on the disposal of assets owned by a passing entity for federal income tax purposes, such as a partnership, limited liability company, or S corporation, then WA capital gains tax will be applied to the portion of such gains intended for individual owners who reside in Washington .
Effects of current and future estate planning
Domicile and residence
Gains or losses from the sale of intangible personal property (such as stocks and other securities) are allocated to Washington under a WA dividend tax if the taxpayer was a Washington resident at the time of the sale. An individual is a resident of Washington if they reside in Washington with the intention of remaining indefinitely. Persons who do not reside in Washington are not subject to the tax.
The taxpayer’s residence (instead of domicile) is unrelated to sales of personal intangible property.
As for the sale of tangible personal property, the location of this property and the residence of the taxpayer are taken into account. For tangible personal property located in Washington at the time of sale, the WA Cap Gains Tax applies regardless of where the taxpayer resides. Conversely, for tangible personal property located outside of Washington at the time of the sale, the WA Cap Gains tax will only apply if the taxpayer was a resident of Washington at the time of the sale and the tangible personal property was located in Washington at some time in the year of sale or the year prior.
Washington law defines a “resident” as an individual who is a resident of Washington unless that individual maintains a home in Washington, maintains a home in a different state, and has not spent more than 30 days of the taxable year in Washington. In addition, an individual is considered a resident if they are not a resident of Washington but maintain a home in Washington and have been in the state for more than 183 days.
Individuals considering moving out of Washington should be wary of any immediate sales of tangible personal property that could result in long-term capital gains. While domicile is an intent-based test, Washington domicile rules are more stringent and can cause WA capital gains tax to be applied to the sale of tangible personal property after relocation.
Gift for life
Lifetime gifting is a staple of many estate plans. A person may want to give gifts for family reasons, for purposes of reducing estate taxes, a combination of both, or other reasons. The WA Cap Gains tax may influence decisions about lifetime gifting as well as the form of such gifting.
Kinds of gifts
Very often, gifts for life take one of two forms: (1) explicit gifts; or (ii) gifts as a matter of trust. Express gifting is the simplest form of gift-giving; The individual grants ownership to the recipient without any conditions. In contrast, gifts in the form of trust require additional planning and management. For gifts of trust, a trust agreement must be drafted, and the grantor must specify the terms of the trust and appoint a trustee. Generally, when a donor makes a gift of appreciable property, the gift giver assumes the donor’s cost basis for the purposes of calculating any capital gains from a subsequent sale of the asset.
If the donor is a Washington resident and the recipient is not a Washington resident, making an express gift of the capital gains asset may be a positive planning strategy to avoid any WA capital gains tax on the sale of the asset; WA capital gains tax will not apply when the asset is sold by a recipient who is not a Washington resident. By contrast, if the recipient of the full gift is also a resident of Washington, the recipient will report the gain on the sale and will be subject to WA capital gains tax law. However, depending on the circumstances, the gain from the sale may be excused due to the exclusion of the recipient of the $250,000.
Gifts in confidence
If a grantor in Washington gives assessed assets to a non-grantor irrevocable trust that is subsequently sold, WA capital gains tax will be avoided because the non-grantor irrevocable trust is not subject to capital gains tax in WA. However, if the grantor transfers the assets to a trust that the customer considers to be owned by the customer for federal income tax purposes (the grantor’s trust), the grantor can still be subject to a WA Cap Gains Tax in Washington upon the sale of the capital asset trust.
It’s also important to consider how capital gains within the trust will be taxed at the federal level. Federal capital gains tax rates are compressed on assets sold by and taxable by a trust and up to the highest bracket with very little gain. If a capital gains tax is planned to be avoided or reduced in WA, a careful examination of the federal tax consequences as well as the Washington consequences must be done.
The basis should also be considered for any gift or property plan that includes appraised assets. Under current federal law, assets transferred upon death receive a basic fair market value adjustment upon the death of the decedent (a so-called “escalating basis”). Holding appraised assets until death can avoid or reduce the capital gains tax payable if the assets are sold during life and those assets are allowed to pass on to ultimate beneficiaries without any capital gains built in. In Washington, the treatment is more favorable to spouses who own community property because all community property, even half of the community property owned by the surviving spouse, receives a principal adjustment upon the death of the first spouse. However, if assets were donated during life, either directly or in trust, the donor’s existing foundation generally passes to the recipient and there is no foundation modification upon the later death of the donor.
Thus, if an individual has assets with significant capital gains built in that may be subject to federal tax or a WA Cap dividend tax if sold, it may be wise to consider holding those assets until death in order to have a progressive basis. Alternatively, make lifetime gifts of assets with a high basis to reduce capital gains (either federal or Washington) if the recipient sells the assets.
Because the strategy of making lifetime gifts to family members and younger generations can be an effective way to reduce federal and Washington estate taxes upon death, many individuals will want to consider assets that may be best given away during life. In making these decisions, the federal tax consequences and WA Cap Gains must be carefully considered as well as the potential estate tax savings.
Many individuals have an existing donor-advised fund or may consider establishing one in the future. In order to qualify for a charitable deduction from the WA Cap Gains Tax, the charitable organization must be “principally directed or operated” in Washington. Many donor-advised funds will not meet these requirements. Individuals should consider the method of their future charitable contributions, in addition to the location in which their donor-advised fund is organized, in order to take advantage of the charitable discount.
If you would like to discuss how the WA Cap Gains Tax may affect your estate plan, please contact one of our attorneys at the estate planning, trusts and real estate practice group.