Editor: Alan Wong, CPA
Gains & Losses
Sec. 1(h) taxes adjusted net capital gains of individuals at rates determined by the amount at which the gain would otherwise be subject to tax at the ordinary income tax rates. A 0% rate applies to adjusted net capital gains that would otherwise be subject to the 10% or 15% tax rate. A 15% rate applies to adjusted net capital gains that would otherwise be subject to tax at the 25%, 28%, 33%, or 35% tax bracket. A 20% rate applies to adjusted net capital gains that would otherwise be subject to the 39.6% tax rate.
Net capital gain is defined as the excess of net long-term capital gains over net short-term capital losses. Adjusted net capital gain is defined as net capital gains reduced (but not below zero) by the sum of (1) unrecaptured Sec. 1250 gain (taxed at a maximum rate of 25%) and (2) 28% rate gain (net collectibles and Sec. 1202 gains), plus qualified dividend income. Taxpayers can elect to reduce net capital gain (but not below zero) by the amount they take into account as ordinary investment income under Sec. 163(d)(4)(B)(iii).
The capital gain tax computation seemingly should be easy, but often it is not. The complexity comes from the phaseout of the 0% and 15% rates as other taxable income rises. It takes 27 lines in the IRS qualified dividends and capital gain tax worksheet to work through the computations (Form 1040 Instructions (2013), p. 43). With a good understanding of the mechanics, preparers can spot opportunities to advise clients to take advantage of the 0% rate and minimize the 20% rate.
This flowchart is designed to quickly determine the tax on capital gains and dividends, based on the taxpayer's taxable income. It is for a single taxpayer, but numbers can easily be modified for taxpayers with a different filing status and updated for the change in tax brackets each year. The flowchart and discussion assume adjusted net capital gain includes only net capital gains and qualified dividends.
The flowchart shows how adjusted net capital gain is taxed at various income levels, using the 2014 tax brackets. The first column is for taxable income up to $36,900, the top of the 15% ordinary income bracket. The second column is for taxable income up to $406,750, the top of the 35% bracket. The third column is for income exceeding $406,750, the start of the 39.6% bracket.
A key point in understanding the computations is to know that the taxpayer's tax is the sum of two computations. The first is the tax on adjusted net capital gain. The second is the tax on the taxpayer's other taxable income. Itemized deductions and personal exemptions first reduce other adjusted gross income (but not below zero) and then are applied against adjusted net capital gain.
When the taxpayer's only income is adjusted net capital gain, or other taxable income is zero or negative, computing tax is simple. For a single taxpayer, the first $36,900 of adjusted net capital gain is not subject to tax, the next $369,850 is taxed at 15%, and adjusted net capital gain that exceeds $369,850 is taxed at 20%. It is still simple even when the taxpayer has other taxable income, if the sum of it and adjusted net capital gain is $36,900 or less, in which case adjusted net capital gain is still subject to the 0% rate.
The phaseout of the 0% and 15% capital gain rates is determined by the amount of the taxpayer's taxable income. As shown in the second column in the exhibit on the next page, when a taxpayer has taxable income exceeding $36,900 but less than or equal to $406,750, the adjusted net capital gain is all taxed at 15%. However, if a taxpayer has other taxable income less than $36,900, a portion of the adjusted net capital gain is taxed at the 0% rate.
An example illustrates each column in the flowchart. In each example the taxpayer is single. Tax amounts do not include any applicable net investment income tax.
Example 1: The taxpayer has $36,900 of taxable income that consists of adjusted net capital gain of $16,900 and other taxable income of $20,000. The tax is $2,546, consisting of $2,546 tax on the $20,000 of other taxable income ($907.50 plus 15% of the excess over $9,075) and no tax on the adjusted net capital gain.
Example 2: The taxpayer has taxable income of $150,000 that consists of adjusted net capital gain of $100,000 and $50,000 of other taxable income. The tax is $23,356, consisting of $8,356 of tax on the $50,000 of other taxable income ($5,081.25 plus 25% of the excess over $36,900) and $15,000 tax on the $100,000 of adjusted net capital gain (all taxed at 15%). Alternatively, if taxable income was still $150,000 but consisted of other taxable income of $26,900 and $123,100 of adjusted net capital gain, then $10,000 ($36,900–$26,900) of the adjusted net capital gain would be taxed at the 0% rate and the balance of it at the 15% rate.
Example 3: The taxpayer has taxable income of $600,000 that consists of adjusted net capital gain of $100,000 and $500,000 of other taxable income. The tax is $175,046, consisting of $155,046 on the $500,000 of other taxable income ($118,118.75 plus 39.6% of the excess over $406,750) and $20,000 on the $100,000 of adjusted net capital gain (all taxed at 20%). In the alternative, if taxable income was still $600,000 but consisted of other taxable income of $100,000 and $500,000 adjusted net capital gain, then $306,750 ($406,750–$100,000) of the adjusted net capital gain would be taxed at 15% and the balance of it at 20%. As a third alternative, if taxable income was still $600,000 but consisted of other taxable income of $30,000 and $570,000 of adjusted net capital gain, then $6,900 ($36,900–$30,000) would be taxed at the 0% rate, $369,850 ($406,750–$36,900) at 15%, and the balance at 20%.
The flowchart does not reflect alternative minimum tax (AMT) considerations. AMT also taxes adjusted net capital gain at the 0%, 15%, and 20% rates, with the applicable phaseouts as income increases. However, alternative minimum taxable income is often different from ordinary income, and AMT does feature graduated rates. At higher income levels, AMT will need to be calculated.
Knowing how the tax on adjusted net capital gains is calculated allows tax advisers to take advantage of opportunities to use the 0% rate and to minimize the 20% rate. Taxpayers with a significant portion of their income as adjusted net capital gain present ideal planning opportunities for tax savings.
EditorNotes
Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP in New York City.
For additional information about these items, contact Mr. Wong at 212-792-4986 or .
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP