The United States hasn’t lowered its capital gains tax rate in more than two decades. But President Trump just floated the idea of reducing, or even outright eliminating the capital gains tax, ahead of midterm elections. If that actually happens, we could see one of the biggest wealth transfers in American history.
The last time something like this happened, the S&P 500 went on to increase more than 70% over the following four years, and created new all-time highs.
But what’s the chance of something like this actually passing? If even part of this becomes law, the impact would be enormous. This could also impact everyone who owns a home worth under $2 million, which is a lot of homeowners. So let’s break down exactly what’s being proposed and how it’s going to affect you. Before we dive into the details, join 41,000+ smart investors who get these updates first thing right in their inbox for free, by clicking here:
Let’s talk about the capital gains tax. Capital gain is just profit on something you sold, like a stock you bought for $1000 and sold for $5000. Once that $4000 capital gain is in your hands, the IRS wants its piece. However, you might pay less or more depending on how long you held the stock.
If you held for less than one year, it’s called a short term capital gain. This is treated just like ordinary income at the normal tax rate, which goes up to 37%.
But if you hold for longer than a year, you get “long term capital gains.” This is treated very differently, with taxes ranging from 0% to 15% to 20%, all depending on how much money you make. Sometimes these benefits are so crazy that a married couple can realize almost $100,000 per year of long term capital gains, and pay nothing to the IRS. And that’s before including the standard deduction which could potentially give that person another $32,000 tax free.
All this comes with two catches:
Capital gains stack on top of your ordinary income. They don’t replace it. So if you already made $90,000 at your job, your income fills up the bracket and the gains sit on top of it.
Once your income exceeds $200,000 single or $250,000 married, there’s a 3.8% “Net Investment Tax” which gets added on top of your capital gains rate. So the top tax bracket actually goes up from 20% to about 23.8%.
The worse part is that those thresholds have not been adjusted for inflation. This is where Trump’s new proposal comes in.
When you calculate capital gains, the tax code doesn’t adjust your original investment for inflation. So if you invested $100,000 in 1990 and it’s worth $255,000, you made a $155,000 profit. Congratulations! But the thing is, the $255,000 you have in your account has roughly the same purchasing power today as $100,000 in 1990.
So in real terms, you just broke even after 36 years. But for tax purposes, you owe money on your $155,000 capital gain that is just inflation.
The new discussion aims to index your capital gains to inflation. Say you invested $100,000 in 2020 and it’s worth $150,000 in 2026. Ordinarily, you’d pay tax on that $50,000 but since inflation was 28.8%, your “cost basis” would increase to $128,800, reducing your profits to $21,200. The rest is considered lost to inflation.
On top of this, we also have the home exemption. Right now, when you sell your primary residence, you can exclude up to $250,000 of gain if you’re single, and $500,000 if you’re married filing jointly (as long as you owned and lived in it for at least 2 of the last 5 years). That sounds good, until you realize that homes have the exact same problem as stocks. Those numbers were set by the Taxpayer Relief Act of 1997, and they’ve never been indexed for inflation even once in nearly 30 years. Meanwhile, home values have roughly quadrupled!
Back in 1997 when this act passed, a home clearing $500,000 was very rare. Today that’s not even the price of a basic starter home. The suggestion is that we index that $500,000 to inflation today, bringing the exclusion up to $2 million. That’s what this administration has proposed.
Imagine a couple buys a home in 2005 for $400,000 and sells it for $1.4 million. That’s a $1 million capital gain. With how things stand now, they pay tax on $500,000 plus a 3.8% tax, adding up to $119,000 paid to the IRS. Under the new plan, they will have to pay NOTHING.
Have you ever held onto a house that you otherwise planned to sell, for tax reasons?
But before you think of this as a “Trump Idea,” note that this isn’t the first time something like this has been suggested. The “No Tax on Home Sales Act” would have eliminated dollar-caps entirely for a primary residence. The bipartisan “More Homes on the Market Act” would have doubled the limits to $1 million while also indexing all gains to inflation going forward. So far, both of these have stalled in congress.
This brings us to the question of whether this will actually pass and what impact it will have on the market.
How does this law impact the market right now? When people know they have to pay taxes on selling, sometimes they just don’t sell. If you’re sitting on a stock that’s up 600%, you know that selling it would need you to hand over a quarter to the IRS right away. So some people just decide to not sell and hold on forever even if they want to reinvest the money elsewhere. This is the “lock-in effect.”
This isn’t limited to stocks. In the case of housing, The National Association of Realtors has been warning about what they call a “capital gains cliff” where a growing number of old homeowners with huge built-up gains are now discouraged from selling. Selling would trigger a tax bill, and they would owe an amount that hasn’t been updated for 30 years, while new home prices are oblivious to this information and keep going up.
The most morbid examples are a little sad. An elderly couple bought their home for $200,000 decades ago. Now that home is worth $2 million and they’d love to downsize, but selling it could trigger a massive capital gains tax, and it would cut into the money they’d want to leave to their children. So mostly they’ll just hold onto their house until they pass away — after which their children can inherit it with a stepped-up cost basis, allowing them to freely sell with no capital gains whatsoever.
This sort of thing is very common in estate planning, but it just locks up inventory that the market desperately needs. Changing the rule could let these folks live the life they wanted.
If this were to pass, how would the market react?
Initially, we’d see a surge, most probably, followed by a wave of selling, because people are free to sell after waiting on the sidelines for so long. The last time Capital Gains taxes were lowered in 2003 under George Bush, the market surged over 70% and hit record highs in the following 4 years.
But this brings up another uncomfortable fact, that the rich will probably get richer.
The Institute on Taxation and Economic Policy argued that indexing capital gains would reduce taxes the most for the wealthiest households since they own most of the assets.
This does nothing for the vast majority of Americans unless they invest, and long term, it could lead to an even worse federal deficit. The counter argument is that increased selling might reduce asset prices, allowing people to buy in at cheaper prices than they could otherwise. But that needs people to invest, and let’s be honest, most people aren’t taking that option.
So could this actually pass? Here’s how the press even got wind of this news. In a report from his National Economic Council Director, Kevin Hassett, and former NEC Director Larry Kudlow, it was stated that: “He [Trump] wants to hit people with the things that are promises that we’re going to do if the Republicans have power in the future… So you can expect a lot more policy between now and the midterms… and I’m sure that’s why he was talking to you, Larry, about your great ideas on capital gains.“
Kudlow said he suggested indexing and a bigger home exemption. These were his actual words: “I spoke to him, he liked the idea of the indexing, he liked the idea of a bigger exemption,” and “the boss is very interested” in those ideas. Now, this is a common pattern I’ve noticed. Instead of coming out of with a formal, written policy, Trump likes to float these ideas into social media to see how people react. He pushes them through allies, interviews, and X. If the engagement clicks — BOOM, we’re on. It moves forward.
But sometimes it doesn’t. The 50-year mortgage didn’t take off, and it quietly disappeared (here’s my post on it:)
Now, this one is actually getting a lot of attention, but the bad news is, there’s only two ways to go with this.
Through Congress: Most tax changes need legislation. It’s very unlikely that any of these ideas will become law before the November midterms, and even within the party, Republicans in Congress have floated indexing capital gains in the past, but the issue lacks universal support. The worst part is that it comes with an estimated cost of $200 billion, so winning support will be hard.
Skipping congress: The treasury could just redefine “cost” in the tax code to mean “inflation-adjusted cost” by regulation. Though this sounds brilliant, this has been considered before under George Bush, and it failed because officials concluded the move probably wasn’t legal. The definition of basis in the statute is quite clear, and that doesn’t leave much room for interpretation, making it an uphill legal battle.
But say it does go through, even then the timing gets tricky.
Does this apply to new assets?
Does it retroactively apply even to old assets?
If it applies retroactively, that could cost $1 Trillion in lost revenue. So how would we make up for it?
If it doesn’t apply, most of us wouldn’t see any upside for many, many years, and even then only if inflation stays high. So what’s even the point of passing it?
Given all of this, I think the indexing of capital gains to inflation is most likely not happening. I wouldn’t say it’s a 0% chance, but it’s pretty close. However, I do think there’s a chance of us getting something.
Overall I think indexing capital gains to inflation is a logical move because if all of your gains are just eaten away by inflation, and you’re paying tax on top of that, it makes no logical sense.
If the Trump Administration wants to make an actual difference that can actually pass, they can do four things:
Increase the capital gains home exclusion: This hasn’t been updated since 1997. Increasing the exclusion would allow people to sell and unlock more inventory on the market, while also letting people write off losses on a primary residence.
Increase the $3000 capital loss deduction: Right now, if you make an investment and sell it for a loss, you can only deduct $3000 per year against your income. This limit hasn’t been updated since 1977! In today’s dollars, that’s $16,000, so just update that please?
Index the Net Investment Tax with every other tax bracket: The $200,000 number has been frozen since 2013 and it drags more middle-class people into a “rich person tax” every single year. Fixing it costs almost nothing. Nobody would oppose it.
Stop double-taxing dividends: Dividends have already been taxed at the corporate level, so it makes no sense that they are taxed again at your income tax rate when they flow to you. It could just be boiled down to a long term capital gain tax for all dividends including REITs.
None of this sounds as newsworthy as “Zero capital gains tax,” I get it. But this is the version that could actually pass. It fixes the parts that are broken instead for the people it would make a difference to instead of just making the rich richer.
If you found this useful, like, restack, and share it with a friend who needs to see it:
I’ll see you again next week.
— Graham
No posts
Comments
Nothing yet. Say the first thing.
Sign in to join the conversation.