Could Changes To Capital Gains Make Debt Investing More Attractive?
Long-term investing in assets like stocks and real estate typically works well because it allows the investor to ignore the vicissitudes of the market in the short term. Assets tend to appreciate over time, so a long-term mindset enables the investor to potentially benefit from this appreciation.
The U.S. federal tax code has historically offered another benefit to long-term investing for U.S. investors through the treatment of long-term capital gains, however, recent reports suggest that the Biden administration is looking to eliminate some of these advantages through the proposed federal budget. Should the administration get their way, other types of investing may become more attractive.
Here’s a breakdown of what changes are in store and how investors might adjust.
What’s the situation?
A long-term capital gains tax is applied to any realized gains on assets one has held for more than one year. If one invests in shares of Apple on January 4, 2021, and sells anytime in 2021 for a higher price than they invested, they pay taxes on the capital appreciation the same way they would on wages or other income at their marginal income tax rate. On the other hand, if that investor holds onto the Apple shares until January 5, 2022 or later and then sells to realize a profit, they’ll pay a lower tax rate on the gains. That rate can vary from 0 to 20% depending on the investor’s income (plus a 3.8% investment charge in some cases), vs. the 10-37% range for regular income at the marginal rate. With the power of compounding, this lower tax rate can make a huge difference to what an investor can earn over the course of years or even decades of long-term investing.
What Might Change?
The Biden administration has big spending plans for the federal budget, and is aiming to pay for at least part of that through tax increases. Currently all investors, despite their taxable income, are eligible to make use of the capital gains tax discount. Moving forward, Biden has proposed that individuals who earn more than $1 million in adjusted gross income (or $500K if married but filing separately) per year be subject to taxation of capital gains at their ordinary income tax rate. The administration then plans to move up the top tax rate to 39.6%, bringing the new capital gains tax along with it for those in this tax bracket.
The plan also changes how capital gains are taxed when someone dies and passes along an asset to a beneficiary. Currently, the step up in cost basis as a result of the transfer of ownership to the beneficiary wipes out any taxable event for the inheritor, allowing them to own the inherited asset with a new, usually higher tax basis. The new plan specifies that any inherited asset be subject to capital gains tax if the price of the asset being transferred to the beneficiary has increased since the deceased purchased it. Some exceptions would apply, including only taxing gains after the first $1 million in unrealized profits.
Reaction
Should they go through, these tax changes would only apply to people with over $1 million in adjusted gross income as mentioned, so it’s a relatively small group. Still, other investors might take note, as once this precedent is set it’s possible the threshold will lower over time.
These potential tax changes may make other types of investing attractive. For example, investing in debt could become more lucrative. Returns generated by debt investments are considered income for tax purposes rather than capital gains, therefore the tax treatment of debt investments will not be affected by the proposed changes. Some investors fail to recognize the potential benefits of debt investing because there is no chance for capital growth but the proposed changes may make these investors reconsider their stance.
When done on a platform like on Yieldstreet, investing in debt can offer a wider variety of opportunities and, when well sourced, comes with a potentially attractive risk-reward profile. Investors can target opportunities designed to generate meaningful fixed income. While interest rates at large are quite low – which is also driving both equity market and housing market valuations – there are opportunities in the debt market for a balanced return that are not being targeted by the proposed tax reforms.
Thriving With Change
It’s inevitable that a new presidential administration will have new tax priorities. These tax changes take effort to enact, but often stick beyond the administration’s term. So investors are right to be eyeing the proposed changes to the long-term capital gains tax treatment.
A higher tax rate does not negate the power of compounding and investing for the long term but it does help level the playing field between investing in equities vs debt. As you build out your diversified portfolio, it may be worth having debt on your radar. Check out Yieldstreet for more fixed income and debt investment opportunities.
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