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A new proposal that would subject wealthy investors to taxes on the appreciation of their holdings — even if they don't sell — could come with a host of complexities.
Sen. Ron Wyden, D-Oregon, announced on Tuesday that he is working on a mark-to-market system that would tax unrealized capital gains on assets owned by "millionaires and billionaires."
This levy, assessed annually, would kick in at the same rate as all other income, Wyden said. Currently, the top marginal rate on ordinary income is 37 percent.
In comparison, long-term capital gains are taxed at a top rate of 20 percent.
"Everyone needs to pay their fair share and the best approach to achieving that goal is a mark-to-market system that would require the wealthy to pay taxes on their gains every year at the same rates all other income is taxed," Wyden said in a statement.
He said that he would soon release a white paper outlining how this plan would work.
Principal residences and holdings in 401(k) plans apparently would be excluded.
Tax policy experts noted that while it's early days, implementing a mark-to-market system on brokerage accounts, real estate and other holdings might be easier said than done.
"The elements of valuation and having the liquidity to pay the tax are much larger hurdles when you think about the retail investor," said Steven M. Rosenthal, senior fellow at the Urban-Brookings Tax Policy Center.
Here are a few items that could complicate a mark-to-market tax system for retail investors.
Marking an asset to market means that you're treating it as if you've sold it for fair market value at the end of the year, accounting for the gain or loss incurred.
"It won't help the wealthy to hold the asset for a longer time; that ability to defer the tax would be taken away," said Steve Wamhoff, director for federal tax policy at the Institute on Taxation and Economic Policy.
Figuring out the appreciation of a stock or a mutual fund isn't all that hard to do, but calculating gains on real estate investments, partnership interests and other closely held businesses could present a problem.
"This requires some method to price goods that are in illiquid markets," said Kyle Pomerleau, chief economist at the Tax Foundation. "Ownership of a business isn't traded in the open market, but it has a value."
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Investors could have some wiggle room here. "It could well lead to gaming by taxpayers who use lowball numbers for valuation," said Rosenthal.
How Wyden's proposal will tackle this issue remains to be seen.
However, one potential way around this is to allow the owner of the illiquid asset to defer the mark-to-market tax until he or she sells the holding, Wamhoff said.
"The taxes that are paid upon sale are increased so that you're in the same position as if it had been taxed each year under mark-to-market," he said.
Once you've figured out the value of the asset, you need to find the money to pay the tax.
This could create a crunch for investors who are merely holding an asset and who otherwise wouldn't have the liquidity to pay the levy.
"If you sold a stock and you have cash proceeds, you have money that you can share with the government," said Rosenthal. "If you didn't sell it, you don't have the money to pay the tax."
Marking to market can become more complicated when the asset in question has lost value.
"You must be able to deduct these losses or carry them forward so that you can deduct them at a future time when the asset appreciates," said Pomerleau.
Wyden's plan would allow for individuals to deduct losses, according to Ashley Schapitl, a spokeswoman for the Senate Finance Committee.
How an investor might deduct the loss matters.
For instance, if you were able to deduct losses against your wage income, savvy investors might try to game the tax system this way, said Pomerleau.
"Maybe you have this business that loses money each year, and you use it to harvest your losses and shelter wage income," he said.
There's also the question of what might happen if there's a downturn and asset values dip on a large scale.
"If the loss is ordinary and treated as ordinary, what happens when the stock market goes down?" asked Rosenthal. "Mark to market is attractive when the market is going up, but what happens to revenues when it reverses?"
Finally, the treatment of long-held investments remains uncertain. For instance, your mother-in-law has held shares of IBM for 30 years, and she's subject to the new mark-to-market tax.
Would the tax be phased in? Or will she have to recognize 30 years of gain in one year?
"There are lots of rich people who'll probably hold their stock until death or until they give it away — that's the target," said Rosenthal.
In this case, eliminating the step-up in basis — that's when the heir receives the asset valued as of the date of death — might be a easier to implement, he said.
The step-up allows the beneficiary to sell the asset right away and pay little to no capital gains taxes.
"Paying taxes on gains at death is more sensible and easily accomplished than paying taxes in your lifetime," Rosenthal said.