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Real Estate Excise Tax Changes, New Capital Gains Tax Proposed March 26, 2019

The second prong of majority House Democrats’ plan to boost state spending for the 2019-21 operating budget includes significant changes to the state’s Real Estate Excise Tax (REET), and establishing a new capital gains tax.

HB 2156, “investing in quality prekindergarten, K-12, and postsecondary opportunities throughout Washington with excise taxes on sales and extraordinary profits of high valued assets,” was referred to the House Finance Committee March 26. The bill is scheduled for a public hearing April 4, and a committee vote on April 5.

REAL ESTATE EXCISE TAX

Currently, commercial and residential real estate sales are generally subject to a 1.28 percent tax on the sale price. HB 2156 would change that, beginning in 2020, to a graduated tax as follows:

Sales Price Tax Rate Less than $500,000 0.90 percent $500,000 – $1,500,000 1.28 percent Greater than $1,500,000 – $7,000,000 2.00 percent Greater than $7,000,000 3.00 percent

Undeveloped land, timber or agricultural land, and water or mineral rights would continue to be taxed at the current 1.28 percent rate.

In concept, the plan seeks to provide tax relief to most homeowners, while increasing taxes on high-value home sales. Zillow estimates the median home value in Washington State at $385,400, as of February 2019, and forecasts it increasing 4.7 percent next year to $403,000.

The problem with this approach is commercial property will largely be subject to higher taxes under the House Democrat’s plan. This would further shift the burden onto businesses, which already pay 55 percent or more of state tax revenue.

CAPITAL GAINS TAX

Since Washington has no state income tax, it does not have a capital gains tax either. Legislative Democrats have for several years introduced bills seeking to enact an “excise” tax, rather than an “income” tax, on capital gains. That appears to be a distinction without a difference, since the IRS and every state with a capital gains tax refers to it as a tax on capital gains income. Moreover, the bill would require certain individuals to file a copy of their federal income tax return with the state Department of Revenue to determine capital gains tax liability, further muddling the claim this new

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revenue source is an “excise,” not “income,” tax. Consequently, it is a near certainty that a legal challenge will be filed if a stand-alone capital gains tax is approved.

Nevertheless, HB 2156 would impose a 9.9 percent tax on adjusted capital gains of more than $100,000 in a year for an individual, defined as a natural person. The threshold would be $200,000 for joint federal income tax filers. Both the tax rate and threshold are substantially higher than bills introduced in previous years.

Some small business owners would get caught in this tax by virtue of it applying to individuals owning a disregarded or pass-through entity, namely a partnership, limited liability corporation, S corporation, or trust. Roughly 75 percent of small businesses are pass-through entities for federal tax purposes.

However, the bill includes several provisions seeking to limit the impact on small business owners. These seem to address concerns NFIB raised in years past when testifying on other capital gains bills.

▪ The sale of many high-value assets would be exempt if the property in question is used in a trade or business as defined under the Internal Revenue Code (IRC) Sec. 1231(b)(1). This applies to real property (land and buildings), as well as IRC Sec. 167 depreciable property owned by the business. Sec. 167 allows depreciation of tangible and certain intangible personal property, which would exempt those items from the proposed state capital gains tax. As we understand it, self-created intangible property, like a client list, is generally depreciable under Sec. 167; however, some intangible property a business acquires from others is covered by Sec. 197, not Sec. 167. It appears those intangibles would not be exempt, but may be subject to the deduction described below.

▪ A deduction is allowed for the sale or transfer of “substantially all” (meaning at least 90 percent) assets of or interest in a qualifying family-owned small business. This would apply to real and personal property, including tangible and intangible property, but is limited as follows: o The sale or transfer is at fair market value, and o The seller is a sole proprietor, or • The seller owns at least 50 percent of the business along with other family members, or • The seller and family members own 30 percent of a business themselves, and 70 percent of the business together with another family; or • The seller and family members own 30 percent of a business themselves, and 90 percent of the business combined with two other families, and o The seller or a seller’s family member must have been involved in the business operations on a regular, continuous, and substantial basis for at least five of the eight years preceding the sale or transfer, unless the sale or transfer is to a member of the seller’s family, and o The business had 50 or fewer employees and worldwide gross sales of $7 million or less during the 12 months preceding the sale or transfer.

It is important to keep in mind that the full value of the sale of a qualifying family-owned small business would be deductible against any state capital gains tax liability so long as it meets the criteria. Since businesses are generally more valuable than any one year’s gross sales, the $7 million revenue figure is a cap on annual earnings, not a cap on the value of the business itself.

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In addition, some other assets would be exempt from the proposed capital gains tax, such as: ▪ Certain residential property – single-family homes, including those with accessory dwelling units; a condominium or co-op unit; duplexes and triplexes; townhomes or other multi-family housing designs with three or fewer units; or houseboats. ▪ Retirement accounts – including IRAs, Roth IRAs, 401(k) plans, deferred compensation plans, employee defined contribution or defined benefit plans, and Sec. 403(b) and 408 annuities. ▪ Agricultural land or livestock – provided the property owner has for 10 years had regular, continuous, and substantial involvement in the agricultural operation on the land; or the livestock is owned by a farmer or rancher for more than 12 months. ▪ Timber or timberland – including a real estate investment trust whose gains were from the sale of timber or timberland; the exemption also applies to the sale of Christmas trees.

There is also a provision allowing a deduction of gross business income to prevent taxing the same amounts for both capital gains and state Business & Occupation Tax purposes.

The bill contains an emergency clause, so it would take effect immediately. In addition, the use of an emergency clause blocks a law from being subject to a referendum vote of the people.

For more information, contact NFIB’s Washington State Director Patrick Connor at (360) 786-8675.

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