Washington state's new capital gains tax: a primer

A look at who pays — and why people are challenging it in court.

the Washington State Capitol

The Washington State Capitol and Supreme Court buildings photographed from Heritage Park on Wednesday, Oct. 21, 2020, in Olympia, Wash. (Jovelle Tamayo for Crosscut)

After a decade of failed attempts, Democrats in Washington’s Legislature finally managed to pass a capital gains tax, which kicks in Jan. 1. 

Republicans have fiercely opposed the tax, which applies to profits from selling assets, such as stocks and bonds. They say it will make Washington a less attractive place to do business. GOP lawmakers have also criticized it as a step toward taxing income more broadly.

Democrats, meanwhile, have called the capital gains tax a necessary step toward making the state’s tax system more fair — particularly in a state like Washington, which doesn’t tax income.

Now, with the capital gains tax on the verge of becoming reality, it faces legal challenges that could compromise Democrats’ vision of imposing higher taxes on the wealthy.

Here’s a look at what the tax does, who will pay, and where it stands legally.

 

How the tax works

The 7% capital gains tax applies to profits from selling long-term assets, such as stocks and bonds. 

For the tax to kick in, an individual or married couple’s profits from these types of sales have to exceed $250,000 in a year. 

Even then, the tax applies only to capital gains above the $250,000 threshold. That means if you made $260,000 from selling stocks in a given year, you would pay the tax on $10,000 of that amount, making for a total capital-gains tax payment of $700. 

The $250,000 exemption threshold is set to increase annually by the rate of inflation. 

While the tax becomes effective Jan. 1, the first payments won’t be due until early 2023.

 

Who pays

Most likely, not you.

In addition to the tax applying only to capital gains above $250,000 per year, many transactions are entirely exempt. These include sales of real estate, retirement accounts, timber and livestock used in farming or ranching. Sales of family-owned businesses get a special deduction, too. 

For those reasons, the state Department of Revenue estimates that only about 0.2%  of Washington taxpayers would actually pay the tax. That’s 7,000 people.

 

What it will pay for

Money from the tax is supposed to bankroll an early education bill, The Fair Start For Kids Act. 

That law, which the Legislature also approved in 2021, increases how much the state reimburses child care providers to better match the actual cost of providing childcare.

The new law also aims to make child care more affordable by reducing copays and opening up state-funded child care slots to more people.

State Sen. June Robinson, D-Everett, said state lawmakers have wanted to make big investments in early learning for years, but didn’t have a steady stream of income to make it happen. She called putting the tax money toward preschool and early childhood programs “the best investment that a state and a country can make.” 

“There is really strong research that shows the connection between quality early learning and high school graduation, completing education beyond high school, lower involvement with the criminal justice system — just all those good things,” said Robinson, who was the prime sponsor of the capital gains tax bill in the Legislature. 

Initially, the capital gains tax is expected to raise about $500 million per year that can be used only for K-12 education and early-learning programs. Tax collections above $500 million are to be placed in a school construction account, which pays for school buildings. The amount of money set aside for education programs is set to increase each year by the inflation rate. 

 

Legal argument against the tax

Past court decisions in Washington state have classified income as a type of property. And the state constitution says property must be taxed uniformly — as in, not charging people different rates based on their income level.

Now, two lawsuits are moving forward that aim to overturn the capital gains tax, arguing it is an unconstitutional tax on income. Those two lawsuits, both filed in Douglas County Superior Court, have been consolidated and are moving forward together.

Former state Attorney General Rob McKenna represents one group of plaintiffs challenging the capital gains tax. He said the tax is essentially a graduated tax on income, since it targets one group of people with high earnings, but exempts others. That kind of tax is unconstitutional, McKenna said, because it doesn’t tax income at a flat, uniform rate. 

Moreover, McKenna said, voters in Washington state have repeatedly rejected income taxes, including ones that target the wealthy. Several of those measures would have altered the state constitution to allow for graduated income taxes.

McKenna and many Republican lawmakers see the capital gains tax as Democrats’ way of testing whether the court will reverse its past opinions, opening the door to broader taxes on wealth and income.

“There’s nothing new here,” McKenna told Crosscut in an interview last week. “People just keep recycling the same ideas to get around the fundamental problem, which is that the voters of this state don’t want an income tax.”

 

Legal argument for the tax

Lawyers for the state, meanwhile, argue that the capital gains tax isn’t an income tax, but an excise tax, which applies to the sale or transfer of property. Those types of taxes are legal in Washington state — and the capital gains tax is no different, according to the state’s legal filings.

The state also argues that the Legislature was rightly concerned with the unfairness of Washington state’s tax system when it passed the capital gains tax earlier this year. Because Washington’s tax code relies heavily on sales and property taxes, it is highly regressive, meaning that low and middle-income people pay a higher share of their income in taxes than the very wealthy.

“In imposing the capital gains tax on those with the greatest ability to pay, [the tax] is a small but important step toward rebalancing the state’s tax code,” the state wrote in its court filing.

 

What’s next

A hearing on the consolidated capital gains tax lawsuits is scheduled for early February. After that, a Douglas County judge will issue a ruling on the tax constitutionality — but that’s not expected to be the end of the matter.

The state will almost certainly appeal the lower court’s ruling. The case is expected to be decided by the state Supreme Court. 

That process will likely take many more months.

If the tax is ultimately struck down, state legislators will have to find a different source of funding for the newly approved investments in early childhood education.

But that’s something they most likely won’t have to deal with until 2023, at the earliest. 

While state legislators are scheduled to hold a 60-day session beginning Jan. 10, the final ruling on the capital gains tax won’t come until long after they are scheduled to adjourn their 2022 session, which is slated to run through March.

About the Authors & Contributors

Melissa Santos

Melissa Santos

Melissa Santos is formerly a Crosscut staff reporter who covered state politics and the Legislature.