Executive summary: Washington Supreme Court allows capital gains tax collections to proceed
The Washington Supreme Court will allow for the collection of the state’s capital gains tax, though a lawsuit to determine the constitutionality of the tax is still pending. Impacted taxpayers should prepare to calculate and pay the tax, as well as to closely monitor department guidance and developments in the litigation.
Washington state cleared to begin the collection of capital gains tax
On Nov. 30, 2022, the Washington Supreme Court issued an order permitting the Washington Department of Revenue to begin collecting the state’s new capital gains tax, while a lawsuit to ascertain the tax’s underlying constitutionality is pending. By unanimous decision, the Court issued a stay on a lower court ruling from March 1, 2022, that found the tax was an income tax and thus violated the state constitution prohibiting such taxes. The stay will allow the department to continue with rulemaking, issuing guidance, and ultimately collecting the capital gains tax.
The capital gains tax
In 2021, Washington state enacted a capital gains tax applicable to individuals at a rate of 7% on net gains in excess of $250,000 in a calendar year. The term ‘individual’ refers not only to taxpayers holding capital assets in their individual capacities, but also to individual owners of pass-through or disregarded entities holding capital assets. The taxable amount is based on the amount of federal long-term capital gains reported, although loss carryovers are not allowed. The tax originally became effective on Jan. 1, 2022, with the first returns currently scheduled to be due on April 18, 2023.
The tax provides for a number of exempt assets and deductions. A high-level summary of exempt assets includes:
- All real estate
- A controlling interest in an entity, only to the extent that any long-term capital gain or loss from such sale or exchange is directly attributable to the entity's interest in real property and the sale or exchange was subject to state real estate excise tax
- Assets held in a retirement savings account
- Assets pursuant to, or under imminent threat of, condemnation proceedings by the government
- Cattle, horses or breeding livestock, if more than 50% of the taxpayer's gross income is from farming or ranching
- Property used in a trade or business that is depreciable under section 167(a)(1) of the Internal Revenue Code or that qualifies for expensing under section 179 of the Code
- Timber, timberland or the receipt of Washington capital gains as dividends and distributions from real estate investment trusts derived from gains on the sale or exchange of timber and timberland-
- Goodwill received from the sale of certain auto dealerships
A deduction from the taxable amount is also allowed on gains from the sale of a family-owned small business meeting the statutory definition of a “qualified family-owned small business.” An additional deduction is allowed for charitable contributions in excess of $250,000 made to a qualified organization, with the deduction capped at $100,000. A qualified organization is a non-profit organization eligible to receive contributions as defined in section 170(c) of the Code and that is principally directed or managed within the state of Washington. There are also nuanced provisions for allocating applicable intangible and tangible property subject to the tax.
Washington’s capital gains tax has been challenged on the basis that it violates the state constitution’s uniformity provision. In Washington, income is considered property, and the constitution mandates all state taxes on property be uniform or taxed at the same rate. In addition, any tax on property cannot exceed 1%. Opponents of the tax argued, and a lower court agreed, that the capital gains tax was not uniformly applied because the tax was only imposed on a certain threshold of income and the rate exceeded the constitutional maximum. The lower court also noted other similarities the tax has with an income tax.
The state has contended that the capital gains tax is not a tax on income, but rather an excise tax imposed on activity, i.e., the sale of property generating the gains, rather than property itself. There are no such uniformity provisions nor rate limitations in the state constitution applicable to excise taxes.
It is unclear at this juncture whether the capital gains tax will be upheld by the Court. It is clear, however, that the department is proceeding as though the tax will be sustained. Taxpayers making sales or exchanges of capital assets since Jan. 1, 2022, who are residents of Washington or have property located in Washington subject to the capital gains tax should consult with their tax advisers to determine whether the tax will apply in light of the Court’s decision permitting collection of the tax. A new online system for registering for the tax is anticipated in early 2023, as well as regulations and additional guidance from the department.
In the event that the capital gains tax is found to be unconstitutional by the Court, any capital gains tax already collected by the department would be refunded back to taxpayers. It is not yet known how a refund claim would be made.
Oral arguments are currently scheduled for Jan. 26, 2023. While it is possible the Court will ultimately rule before the tax is due, impacted taxpayers should prepare to calculate and pay the tax, as well as closely monitor department guidance and developments in the litigation.