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Jennifer's Blog

 

How Capital Gains & Losses work for Individuals

 

First, you must separate your long-term gains and losses from your short-term gains and losses. Long-term, for these purposes, means gains or losses from investments you held for more than a year. Gains and losses from investments held for one year or less are short-term. In addition, you must separate your long-term gains and losses into three rate groups:

  (1) the 28% group, consisting of:

  • (1) capital gains and losses from collectibles (including works of art, rugs, antiques, metals, gems, stamps, coins, and alcoholic beverages) held for more than one year;
  • (2) long-term capital loss carryovers; and
  • (3) section 1202 gain (gain from the sale of certain small business stock held for more than five years that's eligible for a 50% exclusion from gross income).

 (2) the 25% group, consisting of "unrecaptured section 1250 gain"-that is, gain on the sale of depreciable real property that's attributable to the depreciation of that property (there are no losses in this group); and

 (3) the 20%/15%/0% group, consisting of long-term capital gains and losses that aren't in the 28% or 25% group-that is, most gains and losses from assets held for more than one year.

Within each of the three groups listed above, gains and losses are netted to arrive at a net gain or loss.

The following additional netting and ordering rules apply:

 (1) Short-term capital losses (including short-term capital loss carryovers) are applied first to reduce short-term capital gains, if any, otherwise taxable at ordinary rates. If you have a net short-term capital loss, it reduces any net long-term gain from the 28% group, then gain from the 25% group, and finally reduces net gain from the 20%/15%/0% group.

 (2) Long-term capital gains and losses are handled as follows. A net loss from the 28% group (including long-term capital loss carryovers) is used first to reduce gain from the 25% group, then to reduce net gain from the 20%/15%/0% group. A net loss from the 20%/15%/0% group is used first to reduce gain from the 28% group, then to reduce gain from the 25% group.

If, after the above netting, you have any long-term capital gain, the gain that's attributable to a particular rate group is taxed at that group's marginal tax rate-28% for the 28% group, 25% for the 25% group, and the following rates for the 20%/15%/0% group:

 (A) 0% in the case of gain that would otherwise be taxed at a regular tax rate below the "maximum zero rate amount" (i.e., for 2021, the 0% capital gains tax rate applies to adjusted net capital gain of up to: $80,800 for joint filers and surviving spouses; $54,100 for heads of household; $40,400 for single filers and for married taxpayers filing separately (for 2020, the 0% capital gains tax rate applies to adjusted net capital gain of up to: $80,000 for joint filers and surviving spouses; $53,600 for heads of household; and $40,000 for single filers and for married taxpayers filing separately);

 (B) 15% in the case of gain that otherwise would be taxed at a regular tax rate below the "maximum 15% rate amount" (i.e., for 2021, the 15% tax rate applies to adjusted net capital gain over the amount subject to the 0% rate, and up to: $501,600 for joint filers and surviving spouses; ($250,800 for married taxpayers filing separately; $473,750 for heads of household; and, $445,850 for single filers (for 2020, the 15% tax rate applies to adjusted net capital gain over the amount subject to the 0% rate, and up to: $496,600 for joint filers and surviving spouses; $248,300 for married taxpayers filing separately; $469,050 for heads of household; and, $441,450 for single filers);

 (C) 20% on gain that otherwise would be taxed in excess of the amount taxed under items (B) and (C).

A 3.8% tax on net investment income applies to taxpayers with modified adjusted gross income (MAGI) that exceeds $250,000 for joint returns and surviving spouses, $200,000 for single taxpayers and heads of household, or $125,000 for married taxpayers filing separately. After the 3.8% tax is factored in, the top rate on capital gain is 23.8%.

If, after the above netting, you're left with short-term losses or long-term losses (or both), you can use the losses to offset ordinary income, subject to a limit. The maximum annual deduction against ordinary income for the year is $3,000 ($1,500 for married taxpayers filing separately). Any loss not absorbed by the deduction in the current year is carried forward to later years, until all of it is either offset against capital gains or deducted against ordinary income in those years, subject to the $3,000 limit. If you have both net short-term losses and net long-term losses, the net short-term losses are used to offset ordinary income before the net long-term losses are used.

Dividends taxed at long-term capital gains rates. Dividends that you receive from domestic corporations and "qualified foreign corporations" are taxed at the same rates that apply to the 20%/15%/0% group mentioned above. However, these dividends aren't part of that group, and aren't subject to the grouping and netting rules discussed above. The 3.8% tax on net investment income applies to dividends.

Some planning suggestions. Since losses can only be used against gains (or up to $3,000 additionally), in many cases, matching up gains and losses can save you taxes. For example, suppose you've already realized $20,000 in capital gains this year and are holding investments on which you've lost $20,000. If you sell the loss items before the end of the year, they will "absorb" the gains completely. If you wait to sell the loss items next year, you'll be fully taxed on this year's gains and will only be able to deduct $3,000 of your losses (if you have no other gains next year against which to net the losses).

Another technique is to seek to "isolate" short-term gains against long-term losses. For example, say you have $10,000 in short-term gains in Year 1 and $10,000 in long-term losses as well. You're in the highest tax bracket in all relevant years (assume that's a 37% bracket for Year 1). Your other investments have been held more than one year and have gone up $10,000 in value, but you haven't sold them. If you sell them in Year 1, they will be netted against the long-term losses and leave you short-term gains to be taxed at 37%. Alternatively, if you can hold off and sell them in Year 2 (assuming no other Year 2 transactions), the losses will "absorb" the short-term gains in Year 1. In Year 2, the long-term gains will then be taxed at only 20% (unless the gains belong in the 25% or 28% group).

Alternative minimum tax/reduction of tax benefits. The favorable rates that apply to long-term capital gain (and qualified dividend income) for regular tax purposes also apply for alternative minimum tax (AMT) purposes. In spite of this, any long-term capital gains you recognize in a year might trigger an AMT liability. This can happen if the capital gains increase your total income enough so that your AMT exemption phases out. The extra income from capital gains may also affect your entitlement to various exemptions, deductions, and credits, and the amounts of those AMT preferences and adjustments, that depend on the amount of your income.

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