Senator Ron Wyden (D-Oregon) has proposed a plan that would tax the capital gains of the highest-earning taxpayers annually, at ordinary income tax rates. Known as “mark-to-market” taxation, this plan would eliminate the “lock in effect” by eliminating deferral, but it would also increase the tax burden on saving and make the tax code more complex.
Under current law, investors are not required to pay taxes on capital gains which accrue to their assets until they are sold. This ability to defer taxes on capital gains reduces the effective tax rate on capital gains, but also creates a “lock in effect.” Investors have an incentive to hold assets for a long period in order to minimize their tax liability. If investors wait to pass property on until death to heirs, they can escape capital gains taxation completely through a process called “step-up basis.”
Wyden has previously proposed taxing some investment income under mark-to-market taxation. He introduced a bill in the 115th Congress focused on transitioning the treatment of financial derivatives to mark-to-market. Specifically, his 2017 bill would have required derivatives traders to value their swaps, options, and forwards contracts at their market rate and report them to the IRS annually for taxation.
While the details of Wyden’s newest plan are not fully fleshed out, there are a few things about mark-to-market taxation of capital gains to consider.
This would be a noticeable tax increase for some taxpayers and raise additional revenue. Under Wyden’s plan, all capital gains owned by the top 0.3 percent of taxpayers would be taxed annually at ordinary income tax rates (ranging from 10 percent to 37 percent), excluding primary residences and 401(k) plans. Currently, long-term capital gains—or those held for longer than a year— are taxed at a lower rate, ranging from 0-23.8 percent (short-term capital gains held for less than a year are taxed at ordinary income tax rates).
By removing deferral, Wyden’s plan would eliminate the lock-in effect for some taxpayers. Individuals subject to Wyden’s proposal would no longer have a choice over when they paid taxes on capital gains. As a result, there would no longer be an incentive to hold on to these assets. Even so, the proposal would also increase the tax burden on savings by accelerating taxes on capital gains and could have an impact on the incentive to save.
Wyden’s plan would also face administrative challenges. For instance, it will be difficult for the IRS to track accrual taxation on non-publicly traded businesses.
Overall, Wyden’s “mark-to-market” proposal strives to subject capital gains to the same treatment as ordinary income. While the plan resolves the “lock in effect” issue and would make the tax code more progressive, it would increase the tax burden on savers and increase tax code complexity.
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