Washington State Capital Gains Tax Held to Be Constitutional

UPDATE: This article was originally published on July 1, 2021. On March 1, 2022, a Douglas County superior court judge struck down the Washington capital gains tax and determined the tax is unconstitutional. On March 24, 2023, the Washington Supreme Court reversed the decision of the Douglas County Superior Court after determining the capital gains tax is appropriately characterized as an excise tax. The Department of Revenue will continue collecting the tax, which was due April 18, 2023.

On May 4, 2021, Washington Governor Jay Inslee signed Senate Bill 5096 into law, creating a new individual excise tax on the sale or exchange of long-term capital assets. Beginning January 1, 2022, the tax is 7% of an individual’s Washington federal net long-term capital gains, adjusted for exemptions and deductions.

The tax applies to the sale or exchange of “long-term capital assets” owned by an individual, whether the individual was the legal or beneficial owner of such assets. In general, taxation is based on the residency of an individual and specific sourcing rules. Only individuals are subject to the tax — it’s not imposed on entities such as corporations, partnerships, and limited liability companies.

What qualifies as taxable long-term capital gains?

“Capital asset” has the same meaning as defined for federal income tax purposes and “long-term capital asset” means a capital asset that is held for more than one year. As such, long-term capital gains from the sale or exchange of stock, bonds, partnership interests, business assets, and other capital assets could be subject to the new tax.

Taxable Washington long-term capital gains start with the net federal long-term capital gain (determined as if alternative minimum tax and opportunity zone provisions did not exist). Adjustments are made for exempt gains and losses, gains and losses allocated outside of Washington, and loss carryforwards not allocated to Washington, to the extent included in the federal long-term capital gain or loss.

Tangible personal property

Long-term capital gains or losses from the sale or exchange of tangible personal property are allocated to and considered taxable in Washington if the property was located in the state at the time of the sale or exchange.

In addition, gains or losses are allocated to Washington even though the tangible personal property was not located in the state at the time of the sale or exchange if all three of the conditions below are met:

• The taxpayer was a "resident" at the time the sale or exchange occurred
• The property was located in Washington at any time during the taxable year of sale or exchange or the immediately preceding taxable year and
• The taxpayer is not subject to payment of an income or excise tax imposed on such capital gains or losses by another taxing jurisdiction.

Real property

Gain generated from the sale or exchange of real property is specifically exempt and not taxable. A real estate excise tax generally applies to the sale or exchange of real property.

Intangible personal property

Long-term capital gains or losses from the sale or exchange of intangible personal property (e.g., stocks and other intangible assets) are allocated to Washington if the taxpayer was domiciled in Washington at the time the sale or exchange occurred.

Who qualifies as a Washington resident?

The tax generally applies to domiciliary resident individuals of Washington, although nonresident individuals could be subject to tax if certain criteria are met. The new law defines a “resident” as an individual who is “domiciled” in Washington during the taxable year.

However, a domiciled resident will not be considered a resident if:

• The individual maintained no permanent place of abode in Washington during the taxable year,
• Maintained a permanent place of abode outside of Washington during the taxable year, and
• Spent not more than 30 days in total in Washington during the taxable year.

For the taxation of gain from the sale of certain tangible personal property, a resident is more broadly defined. For this purpose, a “resident” may also be an individual who is not domiciled in Washington during the taxable year, but who maintained a place of abode in Washington and was physically present in Washington for more than 183 days during the taxable year (often called a statutory resident).

Who is a beneficial owner?

Beneficial owners of capital assets may be subject to the tax. For example, an individual is considered a beneficial owner of long-term capital assets held by a pass-through or disregarded entity for federal tax purposes. This includes a partnership, limited liability company, S corporation, or grantor trust, to the extent of the individual’s ownership interest in the entity as reported for federal income tax purposes. It is important to note a non-grantor trust may be deemed to be a grantor trust under certain circumstances. Therefore, long-term capital gains generated by these pass-through entities may be taxable to the beneficial owners. It is important for owners to obtain pertinent information from their pass-through entities to properly capture the applicable long-term capital gains subject to the tax and claim exemptions.

Exemptions and deductions

There are several specific “exemptions” from the capital gains tax including, but not limited to, gains recognized from the sale of: real estate; assets held under various retirement accounts; privately held entities directly owning real estate; and property depreciable for federal purposes as property used in a trade or business under IRC Section 167(a)(1) (and subject to IRC Section 179 expensing).

In addition, there are three “deductions” allowable against Washington long-term capital gains:

• Standard deduction —

A standard deduction of $250,000 per individual is allowed. For spouses or domestic partners, the combined standard deduction is limited to $250,000 regardless of whether filing joint or separate returns.

• Qualified family-owned small business —

A deduction is allowed for capital gain derived from the sale or transfer of substantially all of a taxpayer’s interest in a qualified family-owned small business. A qualified family-owned small business is specifically defined and includes holding period, material participation, and gross revenue requirements. The ownership requirements address situations where as many as three families may be involved.

• Charitable donations —

A deduction is allowed for the amount donated to one or more qualified organizations during the taxable year in excess of $250,000. The deduction may not exceed $100,000 for the taxable year and may not be carried forward or backward. A qualified organization is a nonprofit organization that is eligible to receive a charitable deduction for federal tax purposes and is principally directed or managed within the state of Washington.

Credits

There is a credit allowed against Washington business and occupation (B&O) tax due for a sale or exchange that is subject to both the B&O tax and the capital gains tax. The credit is equal to the amount of capital gains tax imposed, but it may not exceed the B&O tax otherwise due for the reporting period. Unused credit may not be carried forward or backward and no refunds may be granted for unused credit.

There is also a credit against the capital gains tax equal to the amount of any income or excise tax paid by the taxpayer to another taxing jurisdiction on capital gains, to the extent such capital gains are subject to the Washington capital gains tax. The credit may not exceed the total amount of tax due and there is no carryback or carryforward of any unused credits.

Filing capital gains tax return and paying tax

Although the Washington Supreme Court just ruled on its constitutionality, the Washington Department of Revenue nevertheless expects individuals subject to the tax to be compliant by paying any 2022 tax due on or before April 18, 2023.

The individual is to file a Washington Capital Gains Tax Return (located on the Department’s website) and:

• Report certain detail information about the long-term capital gain/(loss) recognized such as proceeds, basis, gains/(losses),
• Include information about gains/(losses) exempt from the tax, and
• Claim deductions, such as the $250,000 standard deduction and charitable deduction.

Failure to file a timely return (or extension), by April 18, 2023, and pay the tax can result in significant penalties and interest. Currently, there are no 2023 estimated tax payment requirements with respect to the capital gains tax that may be incurred for 2023.

How CLA can help

This capital gains tax is the first of its kind in Washington and the new law is complex. New legislation can be overwhelming, especially when planning for transactions and the associated compliance. CLA’s state and local tax professionals can help you evaluate and plan for Washington capital gains tax impacts.