We’ve had a number of readers send us questions about Initiative 1098 in response to the tax calculator we’ve created. Brian R., who works locally in real estate, asks: “Would there be an exemption for capital gains income, such as someone selling their home or small business?”
The short answer is: Yes. Under Initiative 1098, any potential income tax is calculated based on Adjusted Gross Income (AGI) as defined by the IRS, and federal tax law includes exemptions for capital gains income related to the sale of a home or business.
Specifically, capital gains and/or losses (including those from the sale of a home or business) are calculated on IRS Form 1040 Schedule D, subject to certain exemptions and deductions. The bottom-line number from Schedule D is included in the taxpayer’s AGI, along with wages and other income.
Of course, as with many tax questions, everyone’s situation is unique. So let’s take a look at a couple of examples that show how these exemptions might work in real life.
For homeowners, the IRS states that homeowners filing jointly can exclude up to $500,000 of gain from selling a home on their tax return, provided they have 1) owned and used the home as a main residence for two or more out of the past five years, and 2) have not excluded gain from the sale of another main home in the past two years. There are also exceptions to this rule for changes in employment, health, or other unforeseen circumstance.
Here are two examples of the federal exemption in action from Investopedia:
Suppose that a married couple had bought their home eight years ago for $200,000 and lived in it during that time. Now they’re ready to sell for $450,000 and move to a larger home that costs $400,000 in a less expensive part of the country to accommodate their expanding family. Because of the exclusion, they will not have to pay capital gains tax on the $250,000 profit.
Now let’s look 20 years in the future when our couple wants to retire and downsize to a condo. They sell their large home for $1 million and buy a condo for $750,000. They will have a $600,000 capital gain ($1 million – $400,000) on the house sale. However, they will only have to pay tax on $100,000 of profit because of the $500,000 exclusion. They can use the $250,000 in cash that remains after they buy the condo any way they wish.
As for Washington state and Initiative 1098: in the first example, the capital gain would not be reported as income at all, so Initiative 1098 would not affect the couple’s taxes. In the second example, the couple’s AGI would increase by $100,000. In that case, they might or might not pay an income tax under I-1098, because the first $400,000 of joint income is not taxed under Initiative 1098. It really depends on whether that couple has other income for that year, and if so, how much.
For business owners, capital gains from the sale of business property are also reported on Schedule D. There are a number of different deductions, exemptions and other rules pertaining to the sale of business stock and/or property that could affect AGI. A brief outline is given here, and if you want to wade into the weeds, there’s IRS Publication 544, but here’s a fairly straightforward example:
Let’s say “Chris” started a new business 10 years ago and is now selling it. The net value of the business in year 1 was $0, and it’s net value (and sale price) in year 10 is $500,000. To keep things simple, we’ll assume that Chris: 1) has no other income for the year from the business, since it is being sold; 2) will be filing a joint return, since about 85% of tax returns with AGI over $200,000 are joint; and 3) doesn’t qualify for any capital gains exemptions under the federal tax code, and has no capital losses to offset the sale — in other words, that all $500,000 from the sale of the business will be reported as income.
Under Initiative 1098, Chris’ household would pay just $5,000 in income tax from the sale of the business — an effective tax rate of only 1%. That’s because the first $400,000 of household income is not taxed under Initiative 1098; only the remaining $100,000 is taxed at 5%. What’s more, the state income tax Chris pays is fully deductible on his federal return.
Initiative 1098 will also have positive effects for Chris’ next business. If Chris starts a retail operation of some kind, the capital investments (and other business-related expenses) Chris makes in the business will not be included in his income, and thus won’t be subject to any state income tax. Second, unlike today’s business owners, under Initiative 1098 Chris won’t pay a dime in state Business and Occupation taxes until the business’ gross receipts exceed $1 million.
Have a question about Initiative 1098? Ask us!
Looking for more information about Initiative 1098? Visit the Economic Opportunity Institute website.