On March 24, 2023, the Washington Supreme Court ruled to uphold a controversial capital gains tax on long-term investment profits. The 7% tax applies to sales of stock, bonds, mutual funds and other investments taxpayers have held for more than a year but it doesn’t apply to real estate sales or retirement account funds.
Read on to find out more about the tax and why it’s so controversial.
The Tax Details
The new tax applies only to long-term capital gains of more than $250,000 in a calendar year for single and joint filers.
That may seem like a limited group, but in a state with some of the largest tech companies and other public businesses with stock values that have grown significantly through the years, long-time employees who received stock-based compensation or invested in their companies may be sitting on hundreds of thousands of dollars in capital gains.
“There are a lot of people in Washington State that have significant stock-based compensation from successful companies here,” Lindsay Chuang, partner at Seattle’s Ernst & Young LLP private client services tax practice, says.
Why the Tax Is Controversial
Washington’s tax is controversial because the state constitution essentially prohibits individual income taxes.
Two states that don’t levy income taxes but have investment-related taxes are moving in the opposite direction: Tennessee’s Hall income tax, which taxed stock dividends and bond interest, went away in 2021. And New Hampshire taxes interest and dividend income but is gradually phasing that out: It’s 4% for 2023 and will decrease by 1 percentage point each year until it disappears entirely in 2027.
Because of Washington’s prohibition against individual income taxes, the state legislature had labeled this as an excise tax rather than an individual income tax. The law was signed in 2021, and immediately challenged as unconstitutional.
It went through the lower courts and was finally upheld as constitutional by the Washington Supreme Court in March 2023. The tax became effective Jan. 1, 2022, and the first payments for tax year 2022 were due by April 18, 2023.
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What Are Capital Gains Taxes?
Capital gains represent sales of investments for a profit. The federal government imposes the tax for U.S. taxpayers no matter what state they live in, and most states also tax capital gains as a type of income.
To calculate capital gains, you typically subtract the amount you paid for a stock, bond or mutual fund (called the “cost basis”) from the sale price — the tax is on the profit. If you sold some investments for a loss, you can generally use that to offset gains, which means that you can subtract the losses from the gains and reduce the taxable amount.
The federal government taxes long- and short-term capital gains at different rates. Profits from investments held for more than a year are taxed as long-term capital gains. The rate is 0%, 15% or 20%, depending on your overall taxable income. The federal long-term capital gains tax rate is 15% for most people.
The government taxes short-term capital gains, which are the profits from investments held for one year or less, at your ordinary income tax rate, which is from 10% to 37%.
The Washington capital gains tax applies only to long-term capital gains, so investments held for a year or less are not subject to it. You can offset long-term losses can offset long-term gains but you can’t use short-term losses to offset the long-term gains.
Washington only taxes long-term capital gains of more than $250,000 per year, whether you are single or married. The capital gains tax rate is 7% for profits above this threshold.
Washington also taxes some investments differently from the federal government. Its capital gains tax applies to profits from sales of stocks, bonds, mutual funds and some other investments — but not to real estate sales.
The federal government taxes home-sale profits but if you’ve lived in the house for at least two of the past five years, single filers can exclude up to $250,000 in profits, or $500,000 for married couples filing jointly. There are also some other exclusions.
[READ: Understanding Capital Gains Tax on a Real Estate Investment Property.]
Why Did Washington Pass This Capital Gains Tax?
Washington is home to many tech and other public companies with stock values that have increased significantly through the years. Many of them pay benefits in stock-based compensation, which can be worth hundreds of thousands of dollars but currently are not subject to state income taxes.
Instead, the state currently gets a large portion of its revenue from sales taxes — its sales tax rate of 6.5% — plus an average local tax rate of 2.36% — ranks sixth in the country, according to the Tax Foundation.
Sales taxes tend to affect lower-income residents at a greater rate than those with higher incomes.
“All people pay the same sales tax rate (in the same jurisdiction) on purchases but low-income people spend a larger share of their incomes on consumption and thus pay a larger share of their incomes in sales tax than high-income people,” Richard Auxier, senior policy associate for the Tax Policy Center, says.
In the text of the law, the Washington Legislature said that middle-income families in Washington pay two to four times more in taxes (as a percentage of household income) than top earners in the state and that low-income Washingtonians pay at least six times more than the wealthiest residents.
The state constitution’s prohibition on income taxes made it difficult to raise taxes on wealthy residents.
“They’re trying to provide a way to have high-income residents pay more of the tax burden,” Auxier says. “With an income tax you can do that simply because you can raise the rates on high-income people. But if you don’t have that, it can be challenging.”
The state legislature argued that this capital gains tax was an excise tax rather than an income tax, which is the definition that the Washington Supreme Court ultimately upheld. The state plans to use the money to help fund public education.
“For 134 years, Washington state has been waiting for the day when a fairer tax system came about, one where working people were not carrying an inequitable share of the burden,” Gov. Jay Inslee said in a statement after the ruling. “Today is that day. Washington’s capital gains tax helps right an upside-down tax structure where low-income Washingtonians ultimately expend a much larger share of their income in taxes than our wealthiest residents.”
[READ: What Is the Billionaire Tax and How Would it Work?]
What Happens Now?
The Washington capital gains tax was signed into law in 2021 and contested in court soon afterwards.
“The tax was challenged nearly immediately in 2021 and in the summer of 2022 was ruled unconstitutional by a lower court,” Mike Nelson, manager of government relations for the Washington Society of CPAs, says.
“The state appealed directly to the state Supreme Court and they issued a stay on the lower court’s ruling in November, meaning people were supposed to start planning to pay the tax in April. The state announced that refunds would be given if people paid in April and the tax was struck down by the state Supreme Court after that. Meanwhile, the state had to build a system to collect the tax, since it doesn’t already have a state income tax,” he adds.
The state Supreme Court upheld the law on March 24, 2023, and the first capital gains taxes — for the 2022 tax year — were due by April 18, 2023. “Since they upheld the tax, those refunds never came into play,” Nelson says.
The Washington State Department of Revenue created a web portal for filing the capital gains tax return and paying the tax. The tax will be due each year on the same date as federal income tax returns.
Washington residents with significant stock portfolios are learning about financial planning strategies to deal with the new tax. Some sold stock holdings before 2022 in anticipation of the new law. Others are keeping track of the $250,000 annual exclusion when selling investments, or are using long-term losses to offset some long-term gains and finding other ways to manage the tax.
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