By Wayne M. Schell
The Taxpayer Relief Act of 1997 substantially complicated the computation of the alternative tax on capital gains for individuals. Although Congress made some effort to simplify the procedures in the Internal Revenue Service Restructuring and Reform Act of 1998, many of the complications remain. As a result, the taxation of capital gains continues to be essentially incomprehensible to most citizens, and even some CPAs have decided to let their software do the thinking. Regardless, having a conceptual understanding of how the tax laws work is useful to taxpayers and essential to professionals.
As a basis for discussion, it is necessary to state the obvious. The taxation of capital gains begins by classifying each capital gain or loss and assigning it to one of several categories. Next, each category is netted; categories with net losses offset categories with net gains. Finally, the net gain in each category is taxed at the applicable rate.
Exhibit 1 illustrates the classification and netting procedures. Each capital gain and loss is assigned to one of four categories. In addition to netting short-term gains and losses (column A), taxpayers must calculate the net gain or loss on three categories of long-term gains and losses. Those categories include gains and losses on assets eligible for the maximum 28% tax rate (column B), unrecaptured section 1250 gains eligible for the maximum 25% tax rate (column C), and other long-term gains and losses subject to the 20% or 10% rates (column D). Included in the 28% tax rate category are 1) gains and losses on collectibles held more than one year, 2) taxable IRC section 1202 gains equal to the amount of section 1202 gains excluded (i.e., 50% exclusion on qualified small business stock), and 3) long-term losses carried over to the year. The only item included in the 25% maximum tax category is the portion of the unrecaptured gain on IRC section 1250 property that would have been recaptured if all depreciation were recaptured. Unrecaptured IRC section 1250 gains are limited to, and thus, may not exceed net IRC section 1231 gains. Finally, the gains and losses included in the 20% or 10% category consist of all long-term gains and losses other than those included in the 28% or 25% categories.
Once the gains and losses in each category have been netted, categories with net losses are offset against the net gains in other categories in the following order. If the short-term category generates a net loss, that loss offsets any 28% gains. If the 20% or 10% category produces a net loss, that loss is also offset against 28% gains. If those offsets create or increase a loss in the 28% category, that loss is netted against gains in the 25% category. Any losses not offset by 25% gains are netted against 20% or 10% gains. A resulting 20% or 10% gain is identified as the taxpayer's adjusted net capital gain. A resulting loss offsets any net short-term gain.
If, after the losses have been netted, a long-term gain results, it is eligible for the alternative capital gains tax. The alternative tax requires each category of long-term gain to be taxed in succession. The rate applied to each category is generally the lesser of the applicable capital gains tax rate or the regular tax rates that would otherwise be applied to that amount of income. Conceptually, the alternative tax on capital gains may be viewed as a tax applied to taxable income one layer at a time.
Exhibit 2 visually illustrates how capital gains are taxed. Long-term gains are considered to be included in the taxable income taxed at the taxpayer's highest tax rates. The taxpayer's adjusted net capital gain (20% or 10% gain) is taxed first. It is taken off the top of taxable income and taxed at 20% to the extent that the taxpayer is in the 28% or higher marginal tax bracket. Such gains are taxed at 10% to the extent that the taxpayer falls in the 15% tax bracket. Next, the 28% gains are taxed. Those gains are taxed at a 28% rate unless the taxpayer's regular tax rates would tax them at 15%. To the extent that the regular tax rate would tax those gains at 15%, the 15% rate is applied. Next, the 25% gains are taxed. They are taxed at 25% except to the extent that they fall in the 15% regular tax bracket. Again, any 25% gains that fall in the 15% bracket are taxed at that lower rate. Finally, any taxable income not taxed at one of the alternative tax rates, including any short-term gain, is taxed at the taxpayer's regular tax rates. *
Edwin B. Morris, CPA
Rosenberg, Neuwirth &
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