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Capital Gains and Inflation: A Double Tax?

Background

What role does inflation play when calculating capital gains? Well, it depends on how you look at it.

Biden’s current proposed capital gains tax rates would have some serious implications for high net worth individuals, and concerning effects when adding the cost of inflation.

During his administration, Trump vouched heavily for cutting the tax on capital gains and, when that proposal didn’t pan over well with the then left-leaning Congress, he pushed for indexing of assets for inflation.

Indexing a capital gain would mean revaluing the basis of an asset to match the current market value, rather than keeping the original purchasing price. Trump and other Republicans supported this idea because it raised the cost basis of an asset, and ensured that only the inflation-adjusted gain was taxed.

On the other hand, Democrats felt that taxing only the inflation-adjusted gain meant that investors weren’t paying taxes on the asset’s full value and the entirety of its earned income. Compensating for inflation loss means that capital gains receive a tax break.

Example

An investor purchases an asset in 2001 for $100 and sells it in 2021 for $1,000. The original $100 price of the asset would be revalued today for $150.

Without Indexing:

The asset’s value has increased by $900, so the investor pays tax on $900 in realized capital gains.

With Inflation Indexing:

The original $100 basis is revalued in 2021 as $150 to match the current market value of the asset.

Because the original purchase price was revalued before calculating the total profit, the asset’s value has only increased by $850, so the investor pays tax only on $850 in inflation-indexed realized capital gains.

A Double Tax?

The main argument for inflation indexing of capital gains is that it prevents a supposed “double-tax” on assets.

In the example above, the original value of the asset in 2001 was $100 and is revalued in 2021 for $150. The investor reports a $50 loss.

Without Indexing:

The investor pays tax on the full $900 in gains, which includes the $50 in loss from inflation.

With Inflation Indexing:

The investor subtracts the $50 loss before calculating the total cost of the gain and only pays tax on $850.

Without indexing, investors get taxed on losses. This, in addition to the increased rate proposals, would discourage investments in the market.

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