Tax Code

Tax Code - Capital Gains Tax Rates

While reading misc.invest.*, you may have seen people talking about "long-term gains" or "short-term losses." Despite what it sounds like, they are not talking about investment strategies, but rather a potentially important part of the United States tax code. All this matters because the IRS taxes short-term and long-term gains differently.

The "holding period" is the amount of time you held some security before you sold it. For reasons explained later, the IRS cares about how long you have held capital assets that you have sold. The nominal start of the holding period clock is the day after the trade date, not the settlement date. (I say nominal because there are various IRS rules that will change the holding period in certain circumstances.) For example, if your trade date is March 18, then you start counting the holding period on March 19. Then, you compute the length of the holding period using the day of the month (not the
number of days). Continuing the example, on April 18, your holding period is one month, on April 19 your holding period is more than one month, and so on.

With holding period defined, we can say that a short-term gain or short-term loss is a gain or loss on a capital asset that had a holding period of twelve months or less. Similarly, a long-term gain or long-term loss is a gain or loss on a capital asset that had a holding period of more than twelve months.

Note that a short-sale is considered short-term regardless of how long the position is held open. This actually makes a kind of sense, since the only time you actually held the stock was between when you bought the stock to cover the position and when you actually delivered that stock to actually close the position out. This length of time is somewhere from minutes to a few days.

Net capital gains and losses are fully part of adjusted gross income (AGI), with the exception that if your net capital loss exceeds $3,000, you can only take $3,000 of the loss in a tax year and must carry the remainder forward. Carried-over losses are used to reduce capital gains in a future year, and can be carried over until all used up. If you die with carried-over losses, they are lost. Short-term and long-term loss carryovers retain their short or long-term character when they are carried over.

Discussions from this point on talk about the various tax rates on capital gains. It is important to note that these rates are only the nominal rates. Because capital gains are part of AGI, if your AGI is such that you are subject to phaseouts and floors on your itemized deductions, personal exemptions, and other deductions and credits, your actual marginal tax rate on the gains will exceed the nominal tax rate.

Short-term gains are taxed as ordinary income. Therefore, the nominal tax rate will be whatever tax bracket you are in. More explicitly, it will be taxed at the federal tax rate (bracket) as determined by your taxable (not gross) income line on your federal tax return.

The tax treatment of long-term gains is somewhat more complicated, and depends on your income. Long-term gains are taxed at 5% if you are in the 10% or 15% federal tax brackets (for tax year 2004, up to about $58K for married filing jointly, and less for others). Long-term gains are taxed at 15% if you are fall in one of the higher income-tax brackets (e.g., 25%, 28%, and so on). The long-term gains are included when figuring out your bracket. However, the 5%/15% rate doesn't apply to all long-term gains. Long-term gains on collectibles, some types of restricted stock, and certain other assets are instead subject to a different rate, which may be as high as 28%. And certain kinds of real estate depreciation recapture are taxed no higher than 25%.

Just to keep up with the history, in 2001 and 2002 the tax man offered low rates on sales of assets held 5 or more years. Those rates were 8% and 18% depending on the taxpayer's income-tax bracket. Those so-called "ultra-long-term gains" were swept away by tax-law changes of 2003.

Here's a summary table:

Tax bracket Short-term rate Long-term rate
     10% 10% 5%
     15% 15% 5%
     25% 25% 15%
     28% 28% 15%
     33% 33% 15%
     35% 35% 15%

As you can see, there are some large differences among these rates. While you should never let the income tax "tail" wag the prudent investing "dog," the long/short term distinction is something to keep in mind if you are considering selling at a gain and are getting close to one of the holding period boundaries, especially if you are close to qualifying for long-term treatment.

Now what happens if you have both short-term capital gains and losses, as well as long-term gains and losses? Do short-term losses have to offset short-term gains? Do long-term losses have to offset long-term gains? Well, the rules for computing your net gain or loss are as follows.
You combine short-term loss and short-term gain to arrive at net short-term gain (loss). This happens on Sched D, Part I.
You combine long-term loss and long-term gain to arrive at net long-term gain (loss). This happens on Sched D, Part II.
You combine net short-term gain (loss) and net long-term gain (loss) to arrive at net gain (loss). This happens on Sched D, Part III.
       If you have both a short-term loss and a long-term loss, your net loss will have both short-term and long-term components. This matters if you have a loss carryover (see below).
       If you have both a short-term gain and a long-term gain, your net gain will have both short-term and long-term components. This matters because only the long-term piece gets the special capital gains tax rate treatment.
       If you have a gain in one category and a loss in another, but have a gain overall, that overall gain will be the same category as the category that had the gain. If you have a loss overall, that overall loss will be the same category as the category that had the loss.
If you have a net loss and it is less than $3,000 ($1,500 if married filing separately) you get to take the whole loss against your other income. If the loss is more than $3,000, you only get to take $3,000 of it against other income and must carry the rest forward to next year. When taking the $3,000 loss, you must take it first from the short-term portion (if any) of your loss. The Capital Loss Carryover Worksheet in the Sched D instructions takes you through this.
If you have a net gain, the smaller of the net gain or the net long-term gain will get the special tax rate. This happens on Sched D, Part IV.

  Deductions for Investors

This article offers a brief overview of the deductions that investors can claim when filing US tax returns.

The most significant one is losses. An investor may deduct up to US$3,000 in net capital losses each year using the Form 1040 Schedule D. Additional losses in a calendar year can be carried forward to the following year. Note the key word in the first sentence: net capital losses. For example, if you realized $5,000 in capital gains and $9,000 in capital losses during a tax year, you would have a net capital loss for that year of $4,000. You could deduct $3,000 for that year, and carry forward $1,000 of net loss to the following year's tax return. Another example: if you realized a loss of 4,000 in one stock and a net gain of 4,000 in a second stock, you could not deduct anything because the net loss was zero.

What about margin interest? If you borrow money to purchase securities (not tax-exempt instruments), and if you itemize deductions on Schedule A, you can itemize as investment interest on Schedule A (Interest, not Misc. deductions) the investment interest you actually paid, but only to the extent you had that much investment income. Investment interest that you cannot claim because you didn't have enough investment income can be carried forward to the next year.

Investment income includes investment interest, dividends, and short-term capital gains. You can elect to include mid- and long-term capital gains, but if you do, you cannot choose to elect tax-favored treatment of those gains.

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