On May 4, Gov. Jay Inslee signed into law a new capital gains tax set to take effect Jan. 1, 2022.

This law likely will not impact most people (as explained below). But, for some (the lucky?) the impact could be worth attempting to mitigate through planning.

The key to this new law is not necessarily the tax for most people, but the exemptions and deductions from the tax. This column explores each in turn.

What is the tax?

Starting next year, Washington will impose a 7% tax on capital gains in addition to any other taxes imposed by the federal government. For most people, the federal taxes on capital gains are currently anywhere from 15% to 23.8%.

Accordingly, an additional 7% can make the tax as high as 30.8%.

To complicate matters further, the Biden administration has proposed raising the federal capital gains tax as well. Because Washington has implemented this tax change and the federal government has simply proposed changes, this column will focus solely on Washington.

Still, it’s worth keeping these potential federal changes in the back of your mind.

Will I have to file a tax return?

Yes, taxpayers owing tax under this the new law will have to file a return with the state Department of Revenue. The exact form has not been published yet.

Does it only tax long-term capital gains?

Yes. Short-term capital gains are not taxed under this law. This presents a scenario where the long-term capital gains tax rate can be higher than the ordinary income tax rate and perhaps prompt more short-term trades.

As a reminder, long term means the asset is held longer than one year.

What capital gains are excluded?

Lots.

The Washington capital gains tax does not apply to some big potential sources of capital gains.

Notably, it does not apply to real estate sales and retirement accounts. The list of excluded gains includes another seven items, but the list gets a little too specific to apply generally to most taxpayers. For example, goodwill received from the sale of an auto dealership is exempted.

What deductions are available?

There are two big deductions available that will wipe out (in this columnist’s opinion) the tax liability for most people.

First, there is a standard deduction of $250,000 (same for couples or individuals) against the taxpayer’s capital gains. Thus, if the taxpayer realizes $200,000 of capital gains, that amount is less than the deduction and therefore the taxpayer would not owe any Washington long-term capital gains tax.

The second deduction applies to capital gains attributable to the sale of a qualified family-owned small business. To qualify, the family-owned small business must have worldwide gross revenue of $10 million or less in the 12-month period immediately preceding the sale.

There is another deduction for charitable giving, but it appears rather muted.

A taxpayer can obtain up to an additional $100,000 deduction against the Washington capital gains tax, but to achieve that deduction the taxpayer must effectively give $350,000 to a Washington-based charity.

For example, if a taxpayer has $400,000 of qualifying long-term capital gains, to maximize the charitable deduction the taxpayer would have to give away $350,000 to a Washington charity. Then, the taxpayer would still be left with an approximate capital gains tax of $3,500 ($400K minus standard deduction of $250K and minus the charitable deduction of $100K multiplied by 7%).

Will the law survive?

At least one lawsuit has been filed to challenge the new law. Additionally, a voter initiative could be on the ballot this fall to overturn the new tax. But, for now, it is the law of the land.

Bottom line

As a person starts to anticipate his or her individual potential liability, they must look both at what gains are excluded and the deductions available.

As the average person looks to his or her holdings and related gains triggering events, I believe most people will be delighted to see that the new tax likely will not apply to them.

Indeed, the Washington Department of Revenue estimates that by 2023, only 8,000 taxpayers would be subject to the tax out of a state population of more than 7.6 million. (See Office of Financial Management, 5096 S SB Multiple Agency Fiscal Note Summary.)

By my calculation, that is less than 1/10th of 1% of Washingtonians. As stated above, for the vast majority of us, this new tax will simply not apply.

Beau Ruff, a licensed attorney, is the director of planning at Cornerstone Wealth Strategies, a full-service independent investment management and financial planning firm in Kennewick.