Tax Loophole Enemy

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Tax Loophole Enemy 4 Iowa Capital Gains
Treatment
Charles Bruner Iowa Fiscal Partnership November,
2007
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What is Iowas Treatment of Capital Gains?

• Total exemption from state income tax of capital
  gains for
• livestock used for breeding
• timber held for more than one year
• sales of businesses or farms held for more than
  ten years in which person materially
  participated
• Unique treatment of such capital gains not used
  by any other state or the federal government.

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How Did Iowas Treatment Come About?

• Established in 1989 as a compromise to retain
  some preferential tax treatment of certain
  capital gains at state level, at same time
  federal income tax eliminated its preferential
  treatment of capital gains in exchange for
  massive cuts in overall income tax rates.
• Initially designed to couple with most federal
  tax law changes (including most capital gains)
  but to address argument that some preferential
  treatment should remain for persons who had built
  a business 45 preferential treatment of up to
  17,500 in capital gains
• Dramatically expanded in 1998, with little public
  knowledge, to provide total (rather than 45)
  exclusion and to eliminate the 17,500 limit,
  increasing cost to state treasury more than
  ten-fold

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What Does Capital Gains Tax Exemption Produce?

• Not economic stimulus Has not been used as a
  marketing tool to promote Iowa as a good place to
  grow a business
• Not fairness or meeting taxpayer needs Only
  applies to actual profits/gains, usually accrued
  over a long time and therefore effectively
  sheltered from annual taxation applied to earned
  income.
• Not efficiency Applies primarily to taxpayers in
  top federal income tax brackets, where reductions
  in state income tax produce increases in federal
  tax (taxpayers effectively realize about 70 of
  state tax break).

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What Tax Filers Get Iowa Tax Advantages from
Capital Gains Exemption?
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What Tax Filers Get State Tax Advantages from
Capital Gains Exemptions?
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Capital Gains Beneficiary 1Software Developer

• Ryan Stanley is a computer software developer,
  starting his business in 1990, making a six
  figure income. In 2001, he developed a patented
  software application that attracted the attention
  of a multinational software corporation, who
  bought Ryan Stanleys business for a cool 3
  million, a 2.7 million profit for Ryan.
• Under Iowa capital gains law, Ryan Stanley did
  not pay one penny to Iowa on the 2.7 million
  profit. If Iowa treated capital gains the way
  other states did, Ryan would owe Iowa taxes of
  about 240,000, but his federal taxes would be
  reduced by 70,000 as a result.

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Capital Gains Beneficiary 2Land Speculator

• Peter Oslo invested 20,000 on land adjacent to
  the north side of an Iowa city, which he was
  hoping to eventually develop and materially
  invested in by mowing and otherwise maintaining.
  A decade later, Peter reached a zoning deal with
  the city and developed the land into parcels for
  high income residences, increasing the value of
  the land ten-fold. Peter Oslo sold the land,
  receiving 200,000 on the deal.
• Under Iowa capital gains treatment, Peters
  profit is not subject to any Iowa taxes. If Iowa
  treated capital gains the way other states do, he
  would owe about 16,000 in state taxes on his
  180,000 profit, but this would be offset by a
  lower federal tax bill of 5000.

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Capital Gains Beneficiary 3Farm Widow (Most
Deserving Case Scenario)

• Alma Waters moved into town when her husband
  died, but kept the 1,000 acre farm. Alma had
  participated in the management of the farm with
  her husband, handling the books and making
  decisions on planting and selling crops. Her
  medical expenses piled up, however, and her
  social security and Medicare couldnt cover the
  costs. She built up 15,000 in debt. None of
  her children wanted to farm the land, and she
  finally felt forced to sell it, with a sale price
  of 2.5 million. Since the value of the farm had
  appreciated, she had a capital gains of 1.5
  million over the value when she and her husband
  inherited it.
• Under Iowa law, the capital gain of 1.5 million
  is exempt from Iowa taxation all together. If
  taxed like other states, Alma would owe 135,000
  in state taxes (and 600,000 in federal taxes),
  but still be left with 1,765,000 from the sale.
  She would be taxed on her one-time profit at
  about the same rate as a working family of four
  making 80,000 per year is taxed every year.

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Iowa EITC Family

• Carlos and Angela Garcia married family of four,
  with one 18,000 full-time job as counselor for
  delinquent youth and one 12,000 ¾ time job as
  nurses aid. Pay 650 a month for apartment and
  pinch pennies to make ends meet.
• Currently receive federal EITC of 2,060 but must
  send a good chunk back to the state in state
  income tax obligation of 636
• Refundability of state EITC did not affect this
  family. Increasing EITC rate to 12 would provide
  103 in additional state tax relief for family.
• Garcia family currently pay state taxes on
  hard-earned income while those with large capital
  gains pay nothing.

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Tax Trade-Offs
Give 484 tax filers making over 250,000 a 16 M
state tax break (reduced to 11 M when
corresponding federal income tax set-offs
included). OR Give 180,000 working Iowa tax
filers a tax break through increasing the state
EITC to 12 of the federal break (no federal
offset)
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Options for Changing the Iowa Capital Gains Tax

• Eliminate exemption entirely (first choice).
• Eliminate exemption for all but farm income.
• Limit capital gains preference to first 25,000
  (or some other amount) in gains.
• Limit capital gains preference exemption to 45
  (or some other percentage) of gain.

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The Myth of Soaking the Rich Current Average
Iowa Income Taxes Paid as Percent of AGI --
Resident Filers Only
Note Only resident filers are included in this
table because overall rates are skewed
when nonresident filers are included. The table
shows that very high income Iowans pay only a
slightly higher overall rate than lower income
Iowans. Eliminating the capital gains exclusion
entirely most affects high income tax filers and
makes Iowas income tax more progressive.
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Recommended Options

• Eliminate capital gains exemption to generate 36
  million in state revenue.
• Increase EITC by a commensurate amount (to
  provide at least a 12 credit)
• Provide overall tax cut benefiting 180,000
  working Iowa tax filers while more closing a tax
  loophole that affects the already tax-advantaged
  highest income tax filers