Capital Gains Tax Rate
Posted on October 26, 2008
Filed Under Capital Gains and Losses, Federal Income Tax
A taxpayer should know that if she were to realize a gain on the sale of a long-term capital asset–a capital property held for more than one year, she would be taxed but at a rate lower than that for an item of ordinary income. In contrast, a gain on the sale of a short-term capital asset–a capital property held for one year or less–would be taxed as if it were an item of ordinary income. The distinction between the tax treatment for a capital asset with a long-term holding period and that for a capital asset with a short-term holding period is the key theme of this article. (For a full discussion of how holding period affects the classification of a capital asset, click on my earlier post on this topic, holding period.)
The reader should also know that the deduction from ordinary income for a net capital loss–a situation in which taxpayer’s capital losses for the year are greater than his capital gains–is limited to $3,000 annually. (I use the term “bonus write-off” to describe this deduction from ordinary income.) In particular, the rule is that a taxpayer is allowed to deduct up to $3,000 of this loss annually; but a taxpayer has the option to carry forward any remaining capital loss–the capital loss that remains after subtracting the $3,000 bonus write-off amount–to future tax years. (To avoid needless repetition, when I mention a capital loss carryforward in the remainder of the article, it is net of the $3,000 bonus write-off amount.) In any event, capital losses are deductible in full against capital gains; the $3,000 limit applies only if a taxpayer has a net capital loss for the year.
Capital gains and losses are reported on Schedule D (Capital Gains and Losses) of Form 1040, but the authors of a popular textbook remark that even the Internal Revenue Service admits “the form could be correctly filled out without the taxpayer understanding what was going on.” Daniel Posin & Donald Tobin, Principles of Federal Income Taxation 253 n. 265 (Concise Hornbook Series, 7th ed., West 2005). As one purpose of this web log is to help readers understand the inner workings of the Internal Revenue Code, I will provide a concise introduction to the logic behind the calculation of capital gains and losses. (Note: Click on the Tax Forms page on the navigation menu above to see a copy of Schedule D.)
Before I outline the netting process for sales of capital assets, the reader should note that the complexity of this article is due in large part to the fact that net short-term capital gain is taxed at ordinary income rates and net capital gain at the more favorable capital gains rates. In the federal income tax law, net capital gain is defined as net long-term capital gain in excess of net short-term capital loss. Net capital loss is the excess of capital losses over capital gains. An added complication is that capital gains rates vary according to income tax brackets, that is, taxpayers in higher income tax brackets will pay capital gains taxes at higher rates than those in lower brackets. Finally, transactions involving certain categories of capital assets–for example, collectibles, qualified small business stock (Section 1202 stock), and depreciation recapture on Section 1250 assets–may be taxed at higher rates than transactions involving other types of capital assets.
The first step in determining net capital gain or loss for the year is to separate sales of capital assets into sales of short-term capital assets and sales of long-term capital assets. After an individual works through a complicated netting process that (1) uses short-term capital losses to offset short-term capital gains and long-term capital losses to offset long-term capital gains and (2) compares net long-term capital gain with net short-term capital loss, any resulting net capital gain is taxed at the applicable capital gains rate. If the result of this process is a net capital loss, then $3,000 of this loss may be used to offset ordinary income and any remainder can be carried forward to future tax years.
Sales of Short-Term Capital Assets
Short-term capital gains for the year are compared with short-term capital losses; if the result of this netting process is a net short-term capital gain, then this amount is treated as an item of ordinary income and taxed at regular rates. On the other hand, if the result is a net short-term capital loss and the taxpayer doesn’t sell any long-term capital assets during the year, he may deduct up to $3,000 of this net capital loss and carry forward the remainder.
Sales of Long-Term Capital Assets
Long-term capital gains for the year are compared with long-term capital losses. If the result of this netting process is a net long-term capital gain and the taxpayer doesn’t have an offsetting net short-term capital loss, then this amount is, by definition, a net capital gain that will be taxed at the applicable capital gains rate. Likewise, if the taxpayer has a net long-term capital gain and a net short-term capital loss for the year, then the net short-term capital loss is subtracted from the net long-term capital gain. If the result is positive, the taxpayer has a net capital gain for the year. If, on the other hand, the result of this calculation is negative, that is, if net short-term capital loss exceeds net long-term capital gain, the taxpayer has a net capital loss and may deduct up to $3,000 of this loss in the current year and carry forward the remainder. In addition, if the taxpayer has only a net long-term capital loss for the year, the taxpayer may also deduct up to $3,000 of this net capital loss in the current year and, again, carry forward the remainder.
To repeat, there are four possible outcomes to the netting process for sales of capital assets:
-
A net short-term capital gain and a net long-term capital gain. In this case, the net long-term capital gain is taxed at taxpayer’s capital gains rate and the net short-term capital gain at taxpayer’s ordinary income rate.
-
A net short-term capital loss and a net long-term capital loss. In this situation, the losses are combined and used to offset up to $3,000 of ordinary income; any excess net capital loss may be carried forward indefinitely.
-
A net long-term capital gain and a net short-term capital loss. If after offsetting the two categories the result is a net capital gain, then this amount is taxed at taxpayer’s capital gains rate. On the other hand, if the result is a net capital loss, then up to $3,000 of this loss can be taken as a deduction against ordinary income in the current year with unlimited carryforward of any remaining loss amount.
-
A net short-term capital gain and a net long-term capital loss. If after offsetting the two categories the result is a net short-term capital gain, then this amount is taxed at taxpayer’s ordinary income rate. If the result is a net capital loss, then up to $3,000 of this loss may be deducted from ordinary income with unlimited carryforward of any remaining loss.
Capital Gains Tax Rates
In 2007, net capital gain is taxed at a 5% rate for a taxpayer in the 10% or 15% income tax bracket. For a taxpayer in the 25%, 28%, 33%, or 35% income tax bracket, the tax rate on a net capital gain is 15%. (For an explanation of the concept of income tax brackets, click on my earlier article, tax brackets.) Notice, however, that the regular income tax rate will apply to a gain on the sale of a collectible or qualified small business stock (Section 1202 stock) for a taxpayer in the 10%, 15%, 25%, or 28% income tax bracket; but the maximum tax rate on a gain from the sale of a collectible or Section 1202 stock is 28% even if a taxpayer is in a higher income tax bracket (i.e., the 33% or 35% income tax bracket). The regular tax rate also applies to recapture of depreciation taken on Section 1250 property for a taxpayer in the 10%, 15%, or 25% income tax bracket; at the same time, the maximum tax rate on Section 1250 recapture is 25% even if a taxpayer is in a higher income tax bracket (viz., the 28%, 33%, or 35% income tax bracket). For a convenient summary of rates on capital gains, click on long term capital gains tax rate. For help in deciphering the tax plans of the 2008 presidential candidates, click on capital gains tax rate long.
Supplementary relevant articles on tax rates for capital gains are listed below:
Many happy returns, Roger
[...] could be classified as qualified dividend income, making this dividend income eligible for a lower capital gains tax rate; this is the reason such income is labeled qualified dividend income. Qualified dividend income is [...]