A Democratic initiative, often referred to as the Billionaire's Tax, is proposing to levy a tax on the unrealized capital gains of affluent Americans, a move that has stirred unease within the investment community.

Under the current legislative framework, any increase in the value of an asset, such as stocks, cryptocurrencies, or real estate, remains untaxed until the asset is actually sold. However, a new proposal outlined in the Biden administration's "General Explanations of the Administration's Fiscal Year 2025 Revenue Proposals" suggests a paradigm shift. This proposal would impose taxes on unrealized capital gains, also known as "paper profits," which are gains on assets that are still held and not yet liquidated.

While specifics on the implementation of this proposal remain unclear, consider an example of investors who invested $100,000 in stocks at the start of the year. If by year-end, the value of those stocks appreciated to $125,000, they would be liable for tax on the unrealized $25,000 profit, even without having sold the stocks.

Fortunately, the proposed tax reform is targeted at an extremely affluent segment of the population. Individuals with a net worth exceeding $100 million, a group estimated to number around 10,000 in the United States according to the "2023 Centi-Millionaire Report" by Henley & Partners, a UK-based wealth consultancy, would be the ones affected. New York City, with the highest concentration of such individuals at 775, leads the world in this regard.

Speculation about the implementation of the Billionaire's Tax has been rife for several years, with legislators seeking new revenue streams to address the growing federal debt. In December, Senate Finance Committee Chair Ron Wyden introduced a bill aimed at taxing unrealized gains for those with assets over $1 billion and incomes exceeding $100 million.

Adding to the current apprehension is the unfounded talk on social media suggesting that the tax authorities might also target unrealized capital gains of smaller-scale investors. However, it is crucial to clarify that there has been no proposal from Kamala Harris, the Democratic presidential nominee, to tax unrealized capital gains for the average American.

Should Americans with 401(k)s and brokerage accounts be concerned about the government taxing gains on assets they have not yet sold? The straightforward answer is no. This new tax is designed to affect only a minuscule fraction of the wealthiest Americans. It is part of the Biden administration's broader effort to ensure that the super-rich pay a minimum effective tax rate of 25% on their income. Therefore, there is no need for individuals earning $100,000 annually, who are not part of the $100 million net worth club, to worry about this new federal revenue initiative. At least, not for the time being. If you are not among the mega-wealthy like Elon Musk, Warren Buffett, or Jeff Bezos, this proposal is not applicable to you.

However, if you have substantial wealth invested in a private company, this could be a potential concern. Otherwise, there is little reason to be anxious about this proposal.

"As time progresses, tax laws evolve, and the more the government requires additional tax revenue, the more likely they are to expand this revenue stream," noted Kelly Gilbert, the proprietor of EFG Financial. "So, you might not lose sleep over this in the current year, but it's something to consider in the future."

Moreover, given the current composition of Congress, the likelihood of this tax proposal being enacted into law is slim. "While nothing in Washington, D.C., is impossible, the path to passing a tax on unrealized capital gains through Congress, with the anticipated narrow majorities in both the House and Senate, is not clear," commented Tom Block, a policy strategist at Fundstrat, a Wall Street research firm.

A sweeping Democratic victory in the upcoming November elections would be the sole avenue for this Billionaire's Tax to become legislation.

Furthermore, there are legal challenges that could complicate the passage of such a tax. Harvard law professor Thomas J. Brennan, who discussed this issue in 2021, highlighted numerous obstacles. The attempt to tax unrealized gains could face both legal and practical hurdles.

Nevertheless, it is the potential slippery slope that worries some financial professionals. "The Billionaire's Wealth Tax is akin to a trial run, initially targeting centimillionaires, but it could eventually be broadened," said James Lucier, managing director of Capital Alpha Partners, an independent public policy research firm. "Any tax on paper profits is clearly detrimental and could progressively encompass more individuals over time."

The Biden administration argues that the proposed tax would not only generate necessary revenue but also rectify the current disparity in the tax code. It posits that high-income taxpayers currently enjoy preferential treatment, allowing them to pay lower tax rates compared to middle-class Americans. "Amidst this period of escalating inequality, the long-term fiscal deficit of the United States has grown significantly," the administration stated in its 2025 budget proposal.

The concern is that if this tax is enacted, it could pave the way for taxing the paper profits of a larger number of taxpayers. Critics argue that if the Billionaire's Tax is passed, it is only a matter of time before the current threshold of $100 million is reduced, thereby increasing the pool of Americans subject to unrealized capital gains taxes. "Once implemented, it's likely that the threshold will be lowered to affect more Americans," according to Americans for Tax Reform, a conservative political tax advocacy organization.

"One perspective is that even though it's still called the 'Billionaire's Tax,' it's already set to impact those with only a tenth of that wealth ($100 million)," said Daniel Razvi, senior partner, lead tax attorney, and COO at Higher Ground Financial Group. "It's uncertain whether it wouldn't be reduced to $1 million by the time it becomes law."

Jamie Cox, managing partner at Harris Financial Group, points out that the proposal to tax unrealized capital gains is just one of many ideas being considered to increase government revenue. "This proposal is a red herring," said Cox.

The administration is also considering the elimination of the so-called "step-up" in cost basis at death for all appreciated assets. Under current law, the value of an asset is readjusted to its fair market value on the date of the asset holder's death. If the step-up provision is abolished, the deceased's estate or heirs would be liable for taxes on the appreciated assets.

That said, if lawmakers pass a tax on unrealized capital gains, "it would almost certainly face legal challenges in court," Razvi remarked.

Is the Tax Constitutional?

Razvi notes that most legal experts assume a tax on unrealized gains would be unconstitutional. The 16th Amendment grants Congress the authority to tax "incomes" only. However, a June Supreme Court decision in Moore v. United States has introduced ambiguity. The Court ruled in a narrow context that a Trump-era regulation taxing certain foreign undistributed profits was constitutional. Yet, the Court was explicit that this ruling should not be used to endorse a wealth tax, Razvi added.

This ruling, focusing on foreign investments, has raised apprehensions. Does it open the door for the Biden administration to attempt to pass a tax on unrealized gains on domestic investments?

"It's a trial balloon to see if they can generate additional tax revenues," Gilbert stated. All assets could potentially be subject to this type of tax, including home values, as unrealized gains encompass appreciation on stocks, artwork, collectibles, and homes, according to Gilbert.

Said Cox: "It's challenging to predict the extent of the impact." Therefore, stay informed.

"Taxing unrealized capital gains appears to be the ideal solution for a government urgently in need of new revenue streams," Lucier stated. "We will undoubtedly hear more about this in the future."