Capital gains tax in the United States

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In the United States of America, individuals and corporations pay U.S. federal income tax on the net total of all their capital gains. The tax rate depends on both the investor's tax bracket and the amount of time the investment was held. 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, on dispositions of assets held for more than one year, are taxed at a lower rate.^[1]

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

From 1913 to 1921, capital gains were taxed at ordinary rates, initially up to a maximum rate of 7 percent.^[2] The Revenue Act of 1921 allowed 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 by 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The Tax Reform Act of 1986 repealed the exclusion of long-term gains, raising the maximum rate to 28 percent (33 percent for taxpayers subject to phaseouts).^[2] When the top ordinary tax rates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.

In 2003, the Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the rate on qualified dividends and long-term capital gains to 15%, and to 5% for individuals in the lowest two income tax brackets through 2008.

The 15% tax rate was extended through 2010 as a result of the Tax Increase Prevention and Reconciliation Act of 2005, and through 2012 in legislation signed on December 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.

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

Summary of recent history

As a result of the legislation described above:

• Ordinary dividends and short-term capital gains are taxed at the same rate as ordinary income.
• For qualified dividends and long-term capital gains, the tax rate is 0% for the 10%–15% brackets; 15% for the 25%–35% brackets; and 20% for the 39.6% bracket.

The following table summarizes the effects of legislation since 1998:

*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.

Current law

Regular and capital gains tax rates for 2015^[7]

* 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).

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.

Net Investment Income Tax

Starting in 2013, taxpayers earning income above certain thresholds ($200,000 for singles, $250,000 for married couples filing jointly) pay an additional 3.8% tax on all investment income.^[9] Therefore, the top federal tax rate on long-term capital gains is 23.8%.^[10]

Small company stock

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.^[11] 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.^[12][13] In addition, a problem with alternative minimum tax associated with the sale of company stock was fixed.^[14]

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.^[15]

Inherited property

Under the "step-up in basis" rule in the Internal Revenue Code, an individual who inherits a capital asset and later sells that property is subject to capital gains tax only on the excess of the amount realized at the time of sale over the fair market value of the property at the time the individual inherited the property. This means that the capital gain that had accumulated from the date on which the property was purchased (that is, purchased by the decedent, during his or her life) to the date of death is taxed -- to the individual who inherited the property when he sells that property -- at a tax rate of zero percent.

Carried interest

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.^[16] 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).^[17] This tax treatment, often dubbed the "hedge fund loophole", has been criticized as unfair,^[18][19] 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".^[20]

Rationale

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.^[21]

In the Fiscal Year 2012, the lower tax rate of long-term capital gains meant $38 billion more in the hands of the consumer.^[22] The 2007 capital gains tax revenue of $123 billion was equal to 75% of the Fiscal Year 2007 budget deficit.^[23] Capital gains taxes and tax cuts disproportionately affect high income households, since they are more likely to own assets that generate the taxable gains.^[23]

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.^[24]

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."^[25] By 2007, tax revenues increased by $785 billion and 8 million new jobs were created.^[26]

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."^[21][24]

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 liberal Economic Policy Institute.

"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".^[23][27]

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."^[28]

Deferring and/or reducing

Primary residence

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

Under 26 U.S.C. §121,^[29] an individual can exclude from 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. The tests may be waived for military service, disability, partial residence, unforeseen events, and other reasons.

Real estate lawyer Robert Bruss writes that moving to avoid a long commute to a new job does not qualify as such an unforeseen event.^[30] However, bankruptcy of your present employer would likely permit a homeowner a partial use of the exclusion to move to a new job in a different city.^[31] A taxpayer can move more often to avoid capital gains tax in expensive areas.^[32]

The amount of this exclusion is not increased for home ownership beyond 5 years,^[33] and the exclusion is not available to properties bought by 1031 exchange. 1031 exchange is a way to defer capital gains by investing the proceeds of a sale in "like-kind" property, and its use on rental property can avoid capital gains tax entirely. One strategy is for a homeowner to move out of the primary residence, rent it out temporarily, exchange it for a new house, rent that house out temporarily, and then move into it, thereby deferring capital gains tax.^[34]

Section 121^[29] 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.

Capital losses

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.^[35] 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.^[36]

Deferment strategies

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), or a 1031 exchange.^[37]

• 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.^[38]
• Structured sale annuity (aka Ensured Installment Sale) – Defer and reduce capital gains tax while gaining safety and a stream of guaranteed income.^[39]
• Charitable trust – Defer and reduce capital gains by giving equity to a charity.^[40]
• 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.

See also

• Withholding tax

References

Further reading

• Moore, Stephen (2008). "Capital Gains Taxes". In David R. Henderson (ed.). Concise Encyclopedia of Economics (2nd ed.). Indianapolis: Library of Economics and Liberty. ISBN 978-0865976658. OCLC 237794267. 
• Black, Stephen (2011). "A Capital Gains Anomaly: Commissioner v. Banks and the Proceeds from Lawsuits". St. Mary's Law Journal 43: 113. 

External links

• IRS "Like Kind Exchanges Tax Tips"