Capital gains tax in the United States

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This article is about Capital gains tax in the United States. For other countries, see Capital gains tax.

In the United States of America, individuals and corporations pay U.S. federal income tax on the net total of all their capital gains just as they do on other sorts of income. "Long term" capital gains are generally taxed at a preferential rate in comparison to ordinary income.[1] The amount an investor is taxed depends on both his or her tax bracket, and the amount of time the investment was held before being sold.

Short-term capital gains are taxed at the investor's ordinary income tax rate and are defined as investments held for a year or less before being sold. Long-term capital gains, which are gains on dispositions of assets held for more than one year, are taxed at a lower rate than short-term gains. In 2003, this rate was reduced to 15%, and to 5% for individuals in the lowest two income tax brackets.

The reduced 15% tax rate on qualified dividends and long term capital gains, previously scheduled to expire in 2008, was extended through 2010 as a result of the Tax Increase Prevention and Reconciliation Act of 2005 signed into law by President George W. Bush. This was extended through 2012 in legislation passed by Congress and signed by President Barack Obama on Dec 17, 2010. The American Taxpayer Relief Act of 2012 (signed on January 2, 2013) made qualified dividends a permanent part of the tax code but added a 20% rate on income in the new highest 39.6% tax bracket.

As a result:

  • Ordinary dividend and short-term capital gain: Tax rate is same as ordinary income tax rate.
  • Qualified dividend and long-term capital gain: Tax rate is 0%, 15%, and 20% for 10%~15%, 25%~35%, and 39.6% brackets.

When the taxable gain or loss resulting from the sale of an asset is calculated, its cost basis is subtracted from the amount realized on the sale. The cost basis is equal to the purchase price, adjusted for certain factors such as fees paid (brokerage fees, certain legal fees, sales fees) and depreciation.

History of capital gains tax in the U.S.[edit]

From 1913 to 1921, capital gains were taxed at ordinary rates, initially up to a maximum rate of 7 percent.[2] In 1921 the Revenue Act of 1921 was introduced, allowing a tax rate of 12.5 percent gain for assets held at least two years.[2] From 1934 to 1941, taxpayers could exclude percentages of gains that varied with the holding period: 20, 40, 60, and 70 percent of gains were excluded on assets held 1, 2, 5, and 10 years, respectively.[2] Beginning in 1942, taxpayers could exclude 50 percent of capital gains on assets held at least six months or elect a 25 percent alternative tax rate if their ordinary tax rate exceeded 50 percent.[2] From 1954 to 1967 the maximum capital gains tax rate was 25 percent.[3] Capital gains tax rates were significantly increased in the 1969 and 1976 Tax Reform Acts.[2] In 1978, Congress reduced capital gains tax rates by eliminating the minimum tax on excluded gains and increasing the exclusion to 60 percent, thereby reducing the maximum rate to 28 percent.[2] The 1981 tax rate reductions further reduced capital gains rates to a maximum of 20 percent.

The Tax Reform Act of 1986 repealed the exclusion of long-term gains, raising the maximum rate to 28 percent (33 percent for taxpayers subject to phaseouts).[2] When the top ordinary tax rates were increased by the 1990 and 1993 budget acts, an alternative tax rate of 28 percent was provided.[2] Effective tax rates exceeded 28 percent for many high-income taxpayers, however, because of interactions with other tax provisions.[2] The new lower rates for 18-month and five-year assets were adopted in 1997 with the Taxpayer Relief Act of 1997.[2] In 2001, President George W. Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001, into law as part of a $1.35 trillion tax cut program.

According to USA Today,[4] the Emergency Economic Stabilization Act of 2008 caused the IRS to introduce form 8949 – Sales and Other Dispositions of Capital Assets and introduced radical changes to form 1099-B.

Regular and capital gains tax rates for 2009[edit]

Ordinary income rate Long-term capital gain rate Short-term capital gain rate Long-term gain on commercial buildings* Long-term gain on collectibles Long-term gain on certain small business stock
10% 0% 10% 10% 10% 10%
15% 0% 15% 15% 15% 15%
25% 15% 25% 25% 25% 25%
28% 15% 28% 25% 28% 28%
33% 15% 33% 25% 28% 28%
35% 15% 35% 25% 28% 28%

* Unrecaptured Section 1250 gain. Applies to the portion of gains on depreciable real estate (structures used for business purposes) that has been or could have been claimed as depreciation.

Note: the dollar amount refers to taxable income, not adjusted gross income (AGI).

Marginal Ordinary Income Tax Rate[5] Single Married Filing Jointly or Qualified Widow(er) Married Filing Separately Head of Household
10% $0–$8,350 $0–$16,700 $0–$8,350 $0–$11,950
15% $8,351– $33,950 $16,701–$67,900 $8,351–$33,950 $11,951–$45,500
25% $33,951–$82,250 $67,901–$137,050 $33,951–$68,525 $45,501–$117,450
28% $82,251–$171,550 $137,051–$208,850 $68,525–$104,425 $117,451–$190,200
33% $171,551–$372,950 $208,851–$372,950 $104,426–$186,475 $190,201–$372,950
35% $372,951+ $372,951+ $186,476+ $372,951+

Short-term capital gains are taxed as ordinary income rates as listed above. Long-term capital gains have lower rates corresponding to an individual’s marginal ordinary income tax rate, with special rates for a variety of capital goods.

Small company stock[edit]

Section 2011 of the Small Business Jobs Act of 2010 exempts 100% of the taxes on capital gains for angel and venture capital investors on small business investments if held for 5 years. However, this exemption only applies to shares of stock. It excludes convertible debt and warrants which are major components of most angel and venture capital arrangements. This is a temporary measure that applies to stock bought after September 27, 2010 but before January 1, 2011.[6] The temporary 100% exclusion of capital gain from the sale of certain small business stock under IRC § 1202 was extended further through 2011 by the H.R. 4853: Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 as a jobs stimulus.[7][8] In addition, a problem with alternative minimum tax associated with the sale of company stock was fixed.[9]

The President’s new budget in year 2011 will propose making permanent the elimination of capital gains taxes on key investments in small businesses, which was passed as a temporary provision in 2010 as part of the Small Business Jobs Act of 2010 the President signed in September. The budget will also propose expanding the New Markets Tax Credit Program to encourage private sector investment in startups and small businesses operating in lower-income communities. [10]

Inherited property[edit]

Under the "step-up in basis" rule in the federal tax code, capital gains tax is forgiven at death. Someone who inherits stock (or other property) and later sells it, is subject to capital gains tax on the difference between what the stock was sold for and what the stock was worth when it was inherited. The capital gain from when the stock was purchased to when it was inherited is taxed at 0%. According to Congressional Research Service economist Jane Gravelle, this "forgiven" capital gain amounts to about half of all capital gains in the US.[11]

Carried interest[edit]

Carried interest—a common means of paying managers in private equity and hedge funds—currently retains the same character of income for the manager as the source of the income; if the source of the income is such that it generates capital gain for the investors, the manager shares in the income as a capital gain (and is taxed at capital gains rates), if the source of the income is such that it generates ordinary income for the investors, the manager shares in the income as ordinary income (and is taxed at ordinary income rates). Carried interest is the share of any profits that the general partners of private equity and hedge funds receive as compensation, despite not contributing any initial funds.[12] Hedge fund "general partners" typically receive two types of compensation for managing such funds: a fee tied to some percentage of the fund’s assets under management (usually around 2%); and a profit share, or "carried interest," tied to some percentage of the profits generated by the fund (usually 20% or thereabouts).[13] This tax treatment, often dubbed the "hedge fund loophole", has been criticized as unfair,[14][15] and the Congressional Budget Office estimates that taxing carried interest as ordinary income would increase federal tax revenue by $10 billion "from 2012 through 2016 and $21 billion from 2012 through 2021".[16]

Rationale[edit]

Top tax rates on long-term capital gains and real economic growth (measured as the percentage change in real GDP) from 1950 to 2011. There is no apparent relationship (correlation = .12) between low capital gains taxes and high economic growth or vice versa.[17]

In the Fiscal Year 2012, the lower tax rate of long term capital gains meant $38 billion less in taxes was paid to the federal government.[18] The 2007 capital gains tax revenue of $123 billion was equal to 75% of the Fiscal Year 2007 budget deficit.[19] Capital gains taxes and tax cuts disproportionately affect high income households, since they are more likely to own assets that generate the taxable gains.[19]

Supporters of taxing long term capital gains at a lower rate than other income say that it encourages investment, which creates jobs and helps the economy grow, even providing more revenue than a higher rate.[20]

According to Mark LaRochelle of the conservative website Human Events, cutting the capital gains rate increases employment. "After the devastating dot-com bust and terrorist attacks of 2001, annual growth averaged just 1.8 percent. But after George W. Bush gradually cut the rate (from 21.19 percent to 16.4 percent by 2003) average annual GDP growth increased a full percentage point, to 2.8 percent."[21] By 2007, tax revenues increased by $785 billion and 8 million new jobs were created.[22]

However, comparing capital gains tax rates and economic growth in America from 1950 to 2011, economist Len Burman found "no statistically significant correlation between the two", even after using a "lag times of five years." Burman shared his data (shown in the chart) with several economists but none came back having discovered a historical relationship between the rates and growth over those six decades. According to Burman, "If they found the relationship, they’re saving it for a special time."[17][20]

There also appears to be "little or even a negative" correlation between capital gains tax reduction, and rates of saving and investment, according to economist Thomas L. Hungerford of the nonpartisan Congressional Research Service.

"Saving rates have fallen over the past 30 years while the capital gains tax rate has fallen from 28% in 1987 to 15% today .... This suggests that changing capital gains tax rates have had little effect on private saving".[19][23]

Studying economic growth and changes to the top marginal tax rates for capital gains (and other personal income) from 1945 to 2010, Hungerford found, "The reduction in the top tax rates appears to be uncorrelated with saving, investment and productivity growth. The top tax rates appear to have little or no relation to the size of the pie."[24]

Deferring and/or reducing[edit]

Primary residence[edit]

Percent of personal income from capital gains and dividends for different income groups (2006).

Under 26 U.S.C. §121[25] an individual can exclude, from his or her gross income, up to $250,000 ($500,000 for a married couple filing jointly) of capital gains on the sale of real property if the owner used it as primary residence for two of the five years before the date of sale. The two years of residency do not have to be continuous. An individual may meet the ownership and use tests during different 2-year periods. Both tests must be satisfied during the 5-year period ending on the date of the sale. There are allowances and exceptions for military service, disability, partial residence and other reasons. The $250K ($500K married filing jointly) exemption is not increased for home ownership beyond 5 years.[26] The $250,000 ($500,000 for a married couple filing jointly) is not available to properties bought by 1031 exchange. Capital gains on rental property can be totally avoided by using 1031 exchange. One strategy that is sometimes employed is for a homeowner to move out of the primary residence, rent it out for a period of time, terminate the rental, exchange for a new house, rent the new house out, terminate the rental, and then move into the new house, thereby deferring capital gains tax.[27] 1031 exchange can also be used to defer capital gains by renting out part of your principal residence.[28]

Section 121[25] provides no benefit if there is a loss on the sale of the property. One is not able to deduct a loss on the sale of one's home.

According to real estate lawyer Robert Bruss, moving to avoid a long commute to a new job does not qualify as an unforeseen event so you can claim a partial principal residence sale tax exemption.[29] In another article, Bruss pointed out that bankruptcy of your present employer would likely permit a homeowner a partial use of the $250K / $500K exemption to allow a homeowner to move to a new job in a different city.[30] A taxpayer can move more often to avoid capital gains tax in expensive areas.[31]

Capital losses[edit]

If an individual or corporation realizes both capital gains and capital losses in the same year, the losses (except losses from the sale of personal property including a residence) cancel out the gains in the calculation of taxable gains. For this reason, toward the end of each calendar year, there is a tendency for many investors to sell their investments that have lost value. For individuals, if losses exceed gains in a year, the losses can be claimed as a tax deduction against ordinary income, up to $3,000 per year ($1,500 in the case of a married individual filing separately). Any additional net capital loss of the individual can be "carried over" into the next year and "netted out" against gains for that year.[32] Corporations are permitted to carry any size capital loss back three years to off-set capital gains from prior years, thus earning a kind of retroactive refund of capital gains taxes. After the carryback, a corporation may carry the unused portion of the loss forward five years.[33]

Deferment strategies[edit]

Capital gains tax can be deferred or reduced if a seller uses the proper sales method and/or deferral technique. The IRS allows for individuals to defer capital gains taxes with tax planning strategies such as the structured sale (ensured installment sale), charitable trust (CRT), installment sale, private annuity trust (no longer valid), and a 1031 exchange.[34]

  • Deferred sales trust – Allows the seller of property to defer capital gains tax due at the time of sale over a period of time.
  • 1031 exchange – Defer tax by exchanging for "like kind" property. Capital gains can be deferred forever by buying a replacement real estate by a business, but not for personal real estate.
  • Structured sale annuity (aka Ensured Installment Sale) – Defer and reduce capital gains tax while gaining safety and a stream of guaranteed income.
  • Charitable trust – Defer and reduce capital gains by giving equity to a charity.
  • Self-directed installment sale (SDIS) – Allows for the deferral of capital gains taxes while removing the risks from buyer default under a traditional installment sale.
Capital Gains Taxation in the United States[35][36]
July 1998 – 2000 2001 – May 2003 May 2003 – 2007 2008–2012 2013–
Ordinary Income Tax Rate Long-term Capital Gains
Tax Rate
Ordinary Income Tax Rate Long-term Capital Gains
Tax Rate
Ordinary Income Tax Rate Long-term Capital Gains
Tax Rate
Long-term Capital Gains
Tax Rate
Ordinary Income Tax Rate Long-term Capital Gains
Tax Rate
15% 10% 10% 10%/8%** 10% 5% 0% 10% 0%
15% 10%/8%** 15% 5% 0% 15% 0%
28% 20% 27.5%/27%* 20%/18%** 25% 15% 15% 25% 15%
31% 20% 30.5%/30%* 20%/18%** 28% 15% 15% 28% 15%
36% 20% 35.5%/35%* 20%/18%** 33% 15% 15% 33% 15%
39.6% 20% 39.1%/38.6%* 20%/18%** 35% 15% 15% 35% 15%
39.6% 20%

*The 2001 rates are listed first, the 2002 – May 2003 rates second.

**The 8% / 18% rate is for capital gains from certain assets / securities held for more than five years.

Note: Short term capital gains were taxed at the same rate as ordinary income for all years in the range of this table.

See also[edit]

References[edit]

  1. ^ See subsection (h) of 26 U.S.C. § 1.
  2. ^ a b c d e f g h i j Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle (ed). "Capital Gains Taxation entry from The Encyclopedia of Taxation and Tax PolicyProject". Retrieved 2007-10-03. 
  3. ^ Tax Policy Center (2012-12-17). "Historical Capital Gains and Taxes". Taxpolicycenter.org. Retrieved 2014-04-15. 
  4. ^ "New rule puts a wrinkle in figuring taxes on stock sales" by Mark Krantz, published in USA Today on February 13, 2012, page 6B
  5. ^ http://www.irs.gov/pub/irs-drop/rp-08-66.pdf
  6. ^ See section 2011 of the Small Business Jobs Act of 2010, Pub. Law No. 111-240, 124 Stat. 2504, 2554 (H.R. 5297) (Sept. 27, 2010). See also [1] and [2] [3].
  7. ^ "Congress Resolves Many Tax Issues During Lame Duck Session". Journalofaccountancy.com. Retrieved 2014-04-15. 
  8. ^ 12/20/2010 by Sanford Millar Contact (2010-12-20). "Tax Relief Act Has Small Bus Investment Incentive | Sanford Millar". JDSupra. Retrieved 2014-04-15. 
  9. ^ "Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010". Schwabe.com. Retrieved 2014-04-15. 
  10. ^ "White House to Launch “Startup America” Initiative | The White House". Whitehouse.gov. 2011-01-31. Retrieved 2014-04-15. 
  11. ^ Chart Book: 10 Things You Need to Know About the Capital Gains Tax| 3. A large share of capital gains is never subject to capital gains tax.| Center on Budget and Policy Priorities
  12. ^ Definition of 'Carried Interest'
  13. ^ Reducing the Deficit: Spending and Revenue Options CBO, March 2011)
  14. ^ Calpers’s Dear Calls Private Equity Tax Break ‘Indefensible’| By Michael B. Marois and Cristina Alesci| bloomberg.com| 13 February 2012
  15. ^ The Bloomberg Way| By James Bennet| theatlantic.com| November 2012 *quote from Michael Bloomberg, former general partner at Salomon Brothers investment bank: "The next tax bill should get rid of carried interest, which is a joke … My friends in the private-equity business think this is such a joke, even they can’t keep a straight face."
  16. ^ Reducing the Deficit: Spending and Revenue Options CBO, March 2011
  17. ^ a b Leonard, Burman (20 September 2012). "Tax Reform and the Tax Treatment of Capital Gains". House Committee on Ways and Means and the Senate Committee on Finance. Retrieved 27 September 2012. 
  18. ^ Tax Expenditure of the Week: Capital Gains| By Seth Hanlon | americanprogress.org| February 23, 2011
  19. ^ a b c The Economic Effects of Capital Gains Taxation Thomas L. Hungerford, June 18, 2010
  20. ^ a b Brendan Greeley (October 4, 2012). "Study Finds Benefit Is Elusive for Low Capital Gains Rate". bloomberg.com. 
  21. ^ Mark LaRochelle (May 8, 2012). "Raising the capital gains tax will not lead to ‘fairness,’ but only slam U.S. job creation". Human Events: Powerful Conservative Voices. 
  22. ^ "Tax code can’t create ‘fairness’". The Detroit News. January 29, 2012. p. A21.  Retrieved from http://www.lexisnexis.com.
  23. ^ The Decline in the U.S. Personal Saving Rate: Is It Real and Is It a Puzzle? Massimo Guidolin and Elizabeth A. La Jeunesse (see figure 1).
  24. ^ Taxes and the Economy: An Economic Analysis of the Top Tax Rates Since 1945 Thomas L. Hungerford, Specialist in Public Finance, Congressional Research Service, September 14, 2012
  25. ^ a b Exclusion of gain from sale of principal residence 26 U.S.C. § 121
  26. ^ See IRS Publication 523.
  27. ^ "1031 Exchange". ThinkGlink. Retrieved 2014-04-15. 
  28. ^ [4][dead link]
  29. ^ Real Estate Notebook, Robert J. Bruss, August 20, 2006
  30. ^ Bruss, Robert J. "Real Estate Mailbag". The Washington Post. Retrieved April 28, 2010. 
  31. ^ Haggerty, Maryann (September 2, 2005). "Real Estate Live". The Washington Post. Retrieved April 28, 2010. 
  32. ^ See subsection (b) of 26 U.S.C. § 1212.
  33. ^ See subsection (a) of 26 U.S.C. § 1212.
  34. ^ Internal Revenue Code §1031, Exchange of Property held for Productive Use or Investment
  35. ^ "Tax Law Changes for 2008–2017." Kiplinger's. <www.kiplinger.com> Published March 2009. Accessed 28i August 2009.
  36. ^ "Federal Capital Gains Tax Rates, 1988–2011". Tax Foundation. Retrieved 8 January 2013. 

Further reading[edit]

External links[edit]