Understanding Capital Gains Tax Rates

The advantage of capital gains, as opposed to ordinary income, is that the basic maximum tax rate on capital gains for property held for more than one year is currently 15 percent. In contrast, the top four ordinary income tax rates are all higher than this, with the top rate for 2005 through 2010 at 35 percent. 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. 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.

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 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. 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.

But, contrary to popular opinion, not all of your long term capital gains are taxed at 15%. Here’s the breakdown of the long-term rates:

Investment Securities
The 5% Rate
Who’s Eligible: Individuals in the 10% and 15% federal income tax brackets with net long-term capital gains from selling investment securities held for more than one year.

More people than you might think qualify for the new 5% rate. Why? Because the 15% bracket covers 2005 taxable income of up to $29,700 for singles, $59,400 for joint filers, $39,800 for heads of households, and $29,700 for married individuals who file separately. Here’s how this rule works in real life. Say you’re a joint filer and have $55,000 of “regular” taxable income in 2005 and a net long-term gain of $10,000 from stock sales. The first $4,400 of gain ($59,400 – $55,000) will be taxed at only 5%. The remaining $5,600 ($10,000-$5,600) will get taxed at the 15% rate you hear so much about. Now let’s say your net long-term gain is $4,400 or less. In this case, you’ll pay only 5% on the entire gain.

The 15% Rate
Who’s Eligible: Individuals in the 25% federal income tax bracket or higher with net long-term capital gains from selling investment securities held for more than one year.

Real Estate (Owned as an Investment)
The 25% Rate

Who’s Eligible: Property owners and real estate investment trust (REIT) investors in the 25% income-tax bracket or higher who hold property for more than one year.

Investment real-estate gains are tricky since they can be taxed in two different ways. If you claim depreciation deductions, at least some of those gains (so-called unrecaptured Section 1250 gains) are taxed at a maximum rate of 25%.

For example, say you own a rental duplex and have deducted $32,000 of depreciation over the years. That depreciation reduces your basis in the property and results in a bigger taxable gain (or smaller loss) when you sell. Now you sell in 2005 for a $100,000 gain. The first $32,000 (the unrecaptured Section 1250 gain) is taxed at a maximum rate of 25%. The remaining $68,000 of gain is taxed at the “general rule” maximum rate of 15%.

If you own shares in a REIT, you can receive capital-gains distributions subject to the 25% maximum rate. This happens when the REIT sells a piece of depreciable property and distributes the profit to its shareholders.

To the extent an unrecaptured Section 1250 gain falls into the 10% or 15% bracket, it gets taxed at that rate.

Collectibles and Small-Business Stock
The 28% Rate

Who’s Eligible: Any collector in the 28% tax bracket or higher; some small-business stock shareholders.

Net long-term gains from collectibles (stamps, coins, baseball cards, and the like) are subject to a 28% maximum rate rather than the usual 15%. This is one reason stocks are a much better investment than Beanie Babies.

To the extent a long-term collectibles gain falls into the 10% or 15% bracket, it’s taxed at that rate.

The 28% maximum rate also applies to the taxable part of a gain from selling certain small-business stock that qualifies for a special 50% gain exclusion rule (under the tax code). Basically, these are shares in relatively small corporations that were originally issued to you and that you’ve owned more than five years. Consult your tax adviser if you think you have any shares fitting this description.

Homes and Small-Business Stock
The 0% Rate

Who’s Eligible: Homeowners who owned and used their home as a main residence for at least two years before selling; some shareholders of small-business stock.

Believe it or not there are a couple of ways you can lock in a gain without paying Uncle Sam a dime. The first is if you sell a home you’ve owned and used as your main residence for at least two years out of the five-year period ending on the sale date. You are allowed to exclude (pay zero federal tax on) up to $250,000 of gain. If you are married, you can potentially exclude up to $500,000.

Even if you don’t meet the two-out-of-five-years rule, you may still qualify for a reduced gain exclusion privilege. If your gain exceeds the amount you can exclude, the difference is treated as a long-term capital gain eligible for the 15% maximum rate (or 5% or 10% if your taxable income is low enough).

As mentioned, up to 50% of the gain from selling certain small-business stock can be excluded from your federal tax return. Again, consult a tax pro if you think you might qualify for this break. (Relatively few people do, but you could be one of the lucky ones.)

While you should never let the income tax “tail” wag the prudent investing “dog,” the long/short term distinction with and the current capital gains tax rate 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.