Effective long-term capital gains tax rates under the Revenue Reconciliation Act of 1990.
This article examines the effects of interaction between phase-out provisions on personal exemptions and itemized deductions included in the 1990 tax act and the nominally reduced maximum capital gains tax rate. This interaction results in a significantly higher effective capital gains tax rate than the perceived maximum rate of 28%.
Research on effective as opposed to nominal rates has been conducted on earnings of retired individuals(2) as well as on self-employment income.(3) No published articles, however, have analyzed the impact that interactive provisions in the 1990 tax act have had on capital gains tax rates, or the act's potential effects on U.S. economic growth or on the real estate industry.
In this article, an historical overview of capital gains tax treatment is presented, followed by a description and analysis of the 1990 tax act's personal exemption and deduction phase-out provisions and their confounding effects on the maximum capital gains tax rate. The fourth section uses graphical analysis to illustrate these interactive effects.
AN HISTORICAL PRIMER
In the interest of stimulating economic growth, investment, and development, the U.S. Internal Revenue Code (the code) has traditionally contained some form of preferential tax treatment for long-term capital gains income, or the gain derived from the sale of capital assets held by a taxpayer in excess of a minimum statutory period.(4) Various forms of favorable treatment have been in effect since 1921. Principally, provisions have been in the form of exclusions from gross income or reduced tax rates on income derived from the sale of capital assets classified as long term rather than short term. For example, just prior to the passage of the 1986 Tax Reform Act, the code provided that only 40% of long-term capital gains income was includable in a taxpayer's gross income, to be taxed along with ordinary income at the taxpayer's marginal tax rate. Because the maximum tax rate on individual ordinary income was 50%, a net effective maximum capital gains tax rate of 20% resulted. As part of its comprehensive reform measures, however, the Tax Reform Act of 1986 eliminated all preferential tax treatment of long-term capital gains income. Thereafter, the full amount of any capital gains, short term or long term, was to be included in a taxpayer's gross income.
While the 1986 Tax Reform Act may have closed many tax loopholes available to higher income taxpayers, it also legislated lower tax rates, thus making the tax structure more progressive. Of course, not all taxpayers benefited equally. For some, the lost "loophole" was not compensated for by reduced tax rates. Certain sectors of the economy, such as real estate construction, sales, investment, and development, were adversely affected in a disproportionate manner as a direct result of the act's sweeping provisions. Since the 1986 act, numerous House and Senate bills have been introduced to return some form of preferential tax treatment on long-term capital gains income. With arguments that the sale of investment assets was primarily undertaken by upper rather than middle and lower income taxpayers, Democrats have generally opposed these efforts. Republicans, however, and in particular President Bush,(5) have supported a reinstatement of capital gains preference as a means to stimulate overall economic growth.
An analysis of data from 1989 tax returns indicates that capital gains activity is not restricted to the wealthy, and an estimated 74% of all taxpayers who reported capital gains income had adjusted gross incomes (AGIs) under $75,000 per year.(6) While the dollar amount of the average capital gain reported increased as AGI increased, the vast majority of taxpayers who reported capital gains activity fell within middle and low income brackets, which tends to undermine the Democratic argument in favor of disallowing preferential tax treatment of long-term capital gains income.
With the exception of the 1990 tax act, all legislative efforts to reintroduce preferential treatment for long-term capital gains since the 1986 Tax Reform Act eliminated it have failed. While reducing the maximum tax rate on long-term capital gains to 28% from 33%, provisions contained in the 1990 tax act do not reinstate preferential tax treatment of these capital gains to nearly the same degree as had been previously enjoyed by taxpayers. By taxing these gains at a ceiling rate below rates applicable to corresponding levels of ordinary income, however, the 1990 tax act seemingly represents a reversal with respect to existing tax policy on capital gains income (i.e., no preference at all). Or does it? By analyzing the effects of other provisions contained in the 1990 tax act, the authors show that the effective maximum long-term capital gains tax rate is significantly higher than the nominal maximum rate of 28% codified in the 1990 tax act. Moreover, in some instances the effective capital gains tax rate is higher than the nominal ceiling rate of 31% now imposed on ordinary income.
THE 1990 TAX ACT
Among its many provisions, the 1990 tax act reduced individual marginal tax rates and streamlined the number of tax brackets. Ordinary income tax rates, which previously ranged from 15% to 33% for individuals were changed to range from 15% to 31%. Further, the previously existing four individual tax brackets of 15%, 28%, 33%, and 28%, were collapsed into three brackets of 15%, 28%, and 31%. The 1990 tax act eliminated the seemingly regressive "bubble" category, in which middle income taxpayers paid a higher 33% marginal tax rate than did the highest income taxpayers, who only paid a 28% marginal tax rate. In addition to these changes, a nominal maximum tax rate of 28% was placed on long-term capital gains, regardless of a taxpayer's ordinary income bracket. Of course, if a taxpayer were in the 15% bracket, the long-term capital gains would be taxed at this lower rate. The greater-than-one-year minimum holding period required to classify income from the sale of capital assets as long term rather than short term was not changed by the 1990 tax act. The new capital gains maximum tax rate represented a 5% reduction from the previously existing maximum rate of 33%, which was based solely on a taxpayer's ordinary income bracket. Other provisions in the 1990 tax act, however, interacted with the stated reductions in these ordinary and capital gains tax rates, raising the stated nominal maximum rates to higher effective rates.(7)
PERSONAL EXEMPTIONS AND DEDUCTIONS PHASE-OUTS
Two categories of confounding provisions are contained in the Revenue Reconciliation Act of 1990. The first area phases out personal exemptions claimed by taxpayers with minimum threshold AGIs. For 1991 these amounts were $150,000 for joint returns, $125,000 for heads of households, $100,000 for singles, and $75,000 for married couples filing separately. More specifically, 2% of a taxpayer's aggregate personal exemption amount, which was valued at $2,150 per exemption in 1991 and $2,300 for 1992, will be disallowed for each $2,500 (or fraction thereof) of AGI over the threshold amount. Depending on the level of AGI, up to 100% of the value of all personal exemptions claimed may be disallowed. These amounts are adjusted for inflation annually. For 1992, the threshold amounts are $157,900 for joint returns, $131,550 for heads of households, $105,250 for singles, and $78,950 for married couples filing separately. For 1993, these amounts will be increased for another inflationary factor. The personal exemption amount was increased as well, to $2,300 for 1992. In 1993, it will be adjusted for inflation.
The second set of confounding provisions reduces the amount of a taxpayer's allowable itemized deductions. The reduction penalty is 3% of the amount by which AGI exceeds a threshold amount. This reduction in allowability is restricted only to itemized deductions other than amounts claimed for medical expenses, casualty and theft losses, and investment interest. It is further limited to a maximum reduction of 80% of the total sum of the deductions that fall into the phase-out category. Threshold AGI levels for the itemized deduction penalty are $100,000 for joint returns, heads of households, and singles, and $50,000 for married couples filing separately. For 1992, these amounts were increased to $105,250 and $52,625, respectively. Similar increases will occur in 1993 as a result of inflationary factors.
For the remainder of this article, and in particular in the following equations and graphs, the 1991 amounts are used. The use of the 1991 data in no way alters the substance or conclusions of the article. Slight changes in the variable of the formulas, resulting from inflationary adjustments to threshold amounts and exemptions, would only cause minute changes to the calculated capital gains tax rate. The substance of the article, that there is a hidden marginal tax rate on capital gains, is unaltered.
CAPITAL GAINS TAX AND THE PERSONAL EXEMPTION PHASE-OUT
As an example of the personal exemption phase-out, consider a single individual in the highest tax bracket with one exemption, which was valued at $2,150 in 1991; an AGI of $125,000, which includes $25,000 of long-term capital gains and $100,000 of ordinary income; and itemized deductions less than the 1991 standard deduction of $3,400. Because of the newly imposed maximum tax rate of 28% on the capital gains, the taxpayer's tentative capital gains tax liability would be $25,000 X .28 = $7,000. As a result of the exemption phase-out, however, the tax liability will actually be $7,132.50, based on an effective capital gains tax rate of .2853. The increased capital gains tax rate is calculated by adding the nominal maximum capital gains rate of 28% to a .53% surcharge associated with the personal exemption phase-out, as calculated below.
Although it affects capital gains as well as ordinary income, the surcharge is computed using marginal tax rates for ordinary income only. More specifically, the .53% personal exemption surcharge is calculated using the following formula:
|Mathematical Expression Omitted~
|r.sub.e~ = The personal exemption surcharge expressed as a decimal rate
.31 = The marginal tax rate on ordinary income
$2,150 = The 1991 value of a personal exemption
N = The number of personal exemptions claimed
AGI = The adjusted gross income
|THRESHOLD.sub.e~ = The minimum relevant threshold level of AGI above which the phase-out penalty applies
Substituting the figures from the preceding example, the exemption phase-out surcharge is calculated as:
|Mathematical Expression Omitted~
For all AGIs above the specified minimum threshold levels, the personal exemption surcharge is a flat rate. The rate increases in direct proportion to the number of personal exemptions claimed, as represented by N in the previous formula. Thus, if the previous example is applied to a taxpayer with four personal exemptions, the effective capital gains maximum tax rate would be 30.12%, which is the 28% nominal capital gains maximum plus four times the .53% personal exemption surcharge associated with the exemption phase-out penalty.
Although not reflected in equation 1, the dollar amount of denied personal exemptions cannot exceed the amount associated with the number of exemptions claimed. Regardless of the number of exemptions claimed, the personal exemption surcharge ends when a taxpayer's AGI exceeds the relevant threshold by $125,000. Thus, for a single taxpayer, the personal exemption surcharge will be added to the nominal capital gains maximum rate for all AGIs above the minimum threshold level of $100,000, but equal to or less than $225,000. The corresponding range of AGIs to which the personal exemption surcharge will apply for married couples filing separately is $75,000 to $200,000. Similarly, for heads of households the range is $125,000 to $250,000, and for married couples filing jointly the range is $150,000 to $275,000.
CAPITAL GAINS TAX AND THE DEDUCTIONS PHASE-OUT
To illustrate the effect of the deduction phase-out penalty on the maximum long-term capital gains tax rate, an example will be constructed. For the sake of simplicity, the effects of the exemption phase-out, although applicable to this example, are ignored. Consider a single taxpayer in 1991 who is in the highest marginal tax bracket; has an AGI of $125,000, which includes $25,000 of capital gains income and $100,000 of ordinary income; and has $3,000 of itemized deductions that are subject to the phase-out penalty of 3%. Although the taxpayer is in the 31% marginal tax bracket for ordinary income, the tentative long-term capital gains tax liability would be $25,000 X .28 = $7,000, according to the maximum long-term capital gains tax rate contained in the 1990 tax act. The actual capital gains tax liability in this example, however, would be $7,232.50, calculated by multiplying the effective capital gains tax rate of .2893 by long-term capital gains. The effective capital gains tax rate is obtained by adding the 28% nominal maximum rate to a .93% surcharge associated with the deduction phase-out.
Even though the deduction surcharge may be applied to capital gains as well as to ordinary income, it is calculated using ordinary income rates. That is, the .93% deduction phase-out surcharge is obtained using the following formula:
|r.sub.d~ = .31|.03(AGI - |THRESHOLD.sub.d~~/(AGI - |THRESHOLD.sub.d~) (2)
|r.sub.d~ = The deduction surcharge rate expressed as a decimal
.31 = The marginal rate on ordinary income
|THRESHOLD.sub.d~ = The minimum threshold level of AGI above which the deduction phaseout penalty will apply
Substituting the example taxpayer's numbers, the deduction surcharge penalty is calculated as:
.93% = .31|.03($125,000 - $100,000)~/($125,000 - $100,000)
As with the personal exemption phase-out penalty, the deduction surcharge is a flat rate that applies to all AGIs above the specified minimum threshold level until the 80% ceiling level is reached. The maximum amount of AGI above which the deduction phase-out penalty ceases to apply is determined by the following formula:
MAX AGI = . 80($DED)/.03 + |THRESHOLD.sub.d~ (3)
MAX AGI = The maximum amount of AGI above which the deduction surcharge penalty ceases
$DED = The dollar amount of qualifying deductions subject to the penalty
Thus, in this example using $3,000 of qualifying deductions subject to the phase-out penalty, the maximum amount of disallowed deductions would be 80% of $3,000, for a deduction loss of $2,400. For a single taxpayer, the 80% ceiling would be reached at an AGI level of $180,000, calculated using equation 3 as:
$180,000 = .80($3,000)/.03 + $100,000
Similarly, if this single taxpayer had $10,000 of qualifying deductions subject to the phase-out penalty, the deduction surcharge penalty would be zero at AGIs of $366,667 or more. Thus, regardless of the dollar value of deductions that qualify for the penalty, the rate of the deduction surcharge is the same for all amounts of AGI assuming they exceed the threshold minimum level. The range of AGIs across which the deduction phase-out penalty applies, however, varies with the dollar amount of qualified deductions subject to the phase-out. The greater the dollar value of the qualified deductions subject to being phased out, the greater the range of AGI levels above the minimum threshold level to which the deduction penalty will be applied.
COMBINED EFFECT OF THE EXEMPTION AND DEDUCTION PENALTIES
The two preceding examples examine the effects of either the personal exemption or the deduction surcharges on capital gains tax rates. In many if not most instances, however, the two penalties will simultaneously apply. Their interactive effect is additive,(8) such that the effective capital gains maximum tax rate is the sum of the nominal maximum capital gains rate plus the personal exemption surcharge and the deduction surcharge. In equation form, this relationship is expressed as:
R* = |r.sub.c~ + |r.sub.e~ + |r.sub.d~ (4)
R* = The effective capital gains tax rate
|r.sub.c~ = The nominal capital gains tax rate
Combining the additive effects of both phase-out penalties on this single-exemption taxpayer's $25,000 of capital gains income results in an effective capital gains tax rate of .2946, calculated as:
.2946 = .28 + .0053 + .0093
Similarly, an individual taxpayer with the same financial situation, but who claims four personal exemptions, would have an effective capital gains tax rate of .3105, which is calculated as .28 + .0212 + .0093, using equation 4. Thus, the combined effect of the personal exemption and deduction phase-out penalties when coupled with long-term capital gains not only increases the effective capital gains tax rate above the new maximum rate of 28%, but can also raise the effective capital gains rate above the maximum marginal rate of 31% imposed on ordinary income.
GRAPHICAL ANALYSIS OF THE EFFECTIVE CAPITAL GAINS TAX RATE
Figures 1 through 5 provide a more complete analysis of the interaction between the 1990 tax act's personal exemption and deduction phase-out penalties and the act's maximum long-term capital gains tax rate. The figures illustrate multiple scenarios rather than highlighting individual examples. The phase-out penalties and their interaction with capital gains tax only apply to taxpayers in the highest ordinary income tax bracket. Because the maximum ordinary in come tax rate of 31% imposed under the 1990 tax act begins at different taxable income levels based on filing status,(9) the different figures examine the effective long-term capital gains tax rate based on filing status. By holding deductions and personal exemptions constant at certain assumed levels, the effective capital gains tax rate can be examined as a function of changing levels of AGI rather than of taxable income. Because the 1990 tax act's exemption and deduction surtax rates are based on AGI rather than taxable income, depicting the effective capital gains tax rate as a function of AGI is more useful to illustrate the interactive relationship. In addition, the graphs also illustrate the effect that increasing the number of personal exemptions has on capital gains tax rates as well as on the dollar amount of qualified deductions subject to the phase-out penalty.
Figure 1 illustrates the relationship between the effective capital gains tax rate and AGI levels for a single taxpayer with $10,000 of qualifying deductions subject to the phase-out penalty and who claims from one to six personal exemptions. As highlighted by the graph, at AGI levels equal to or below $100,000, the effective capital gains tax rate equals the new nominal maximum long-term capital gains rate of 28% created under the 1990 tax act. At AGI levels above the $100,000 threshold, however, not only the maximum marginal rate on ordinary income, but both the .0093 deduction phase-out surcharge and the .0053-per-exemption surcharge are assessed against long-term capital gains. As illustrated in the stepped portion of the graph, the personal exemption surcharge component is a linear function of the number of exemptions claimed. While the graph shows the exemption surcharge stopping at AGI levels above $225,000, the deduction penalty continues up to AGI levels of $366,667 for an individual filing singly.
Figure 2 also illustrates effective capital gains tax rates for a taxpayer filing singly with from one to six personal exemptions, but $20,000 rather than $10,000 of qualified deductions subject to the phase-out penalty is claimed. The isolated effect of increasing the qualifying deductions is made readily apparent by comparing Figures 1 and 2. That is, the range of the AGI levels across which the .0093 deduction surcharge is assessed increases as the dollar amount of qualifying deductions increases, with the maximum AGI level calculated according to equation 3.
Figures 3 through 5 illustrate corresponding relationships between effective capital gains tax rates and AGIs for married couples filing jointly, married couples filing separately, and heads of households, respectively, using the same basic assumptions of $10,000 in qualifying deductions with up to six personal exemptions. The overall shape of the effective capital gains tax rates graphed in Figures 3 through 5 is similar to that depicted in Figure 1. In fact, the only noticeable difference among Figures 1, 3, 4, and 5 results from varying the threshold minimum and maximum levels of AGI between which each of the two surcharges is imposed.
Each of the graphs illustrates the creation of a new bubble bracket for high-income taxpayers with capital gains income. One of the purposes of the 1990 tax act was to streamline tax rates, abolish the regressive income tax bubble bracket that previously existed, and reduce the maximum rate on long-term capital gains income. Changes contained in the act, however, have simply hidden the bubble that was explicitly obvious in the structure of the previous 15%, 28%, 33%, and 28% marginal tax brackets. The interactive effects of both the personal exemption and deduction surcharges contained in the 1990 tax act create a new regressive marginal tax bubble bracket effective at higher minimum levels of AGIs, which causes effective rates to be higher than nominally stated maximum rates. While ostensibly lowering the ceiling tax rate on long-term capital gains income, the 1990 tax act thus has effectively increased the rate and done so in a fashion that penalizes wealthier individuals more than those with lower levels of AGIs.
Most do not object to the idea that those with greater incomes should pay a progressively higher rate of income tax based on their greater ability to pay. A flat tax on capital gains income for income levels above a certain threshold amount, however, seems more efficient, equitable, and appropriate than a complex extension of a regressive bubble bracket at even higher levels of income. An alternative that would more greatly benefit the real estate industry would be the exemption of capital gains income from the interactive tax penalty provisions contained in the 1990 tax act.
The analysis of the effects of the interaction between the personal exemption and deduction phase-out penalties and the nominally lower ceiling tax rate on long-term capital gains contained in the 1990 tax act reveals the questionable achievements of tax equity, simplification, and reform efforts of Congress, especially in terms of stimulating the real estate and investment sectors of our economy. Clearly, the reduction in long-term capital gains tax rates is illusory; in addition, tax rate structures have not in fact been streamlined to include fewer brackets and the regressive bubble bracket has not been completely eliminated. Members of the real estate and investment communities, tax advisors, and counselors should continue to lobby for more meaningful tax reform efforts, including explicit reintroduction of preferential tax treatment for long-term capital gains, which can potentially stimulate long-term growth and revitalize real estate activity in this country.
As discussed in this article, provisions in the 1990 tax act clearly do not indicate any policy reversals or any trend toward stimulating capital gains or investment activity in real estate. On the contrary, the intricate set of personal exemption and deduction phase-out rules that interact with maximum tax rates more likely result in stagnating investment activity and growth in real estate. Real estate investors, taxpayers, appraisers, and counselors will not be fooled by the perception of lower rates on long-term capital gains. Investment activity in the real estate industry and other sectors of the economy will benefit from an actual rather than a nominal reduction of effective tax rates on long-term capital gains.
Linda L. Johnson, MAI, PhD, is currently an associate professor of real estate and finance at Appalachian State University in Boone, North Carolina. She received a PhD from the University of Georgia and a JD from the University of Virginia. Ms. Johnson has published numerous articles on real estate issues.
James A. Fellows, PhD, is currently professor of accounting and taxation at the University of South Florida in St. Petersburg, Florida. He received a PhD from Louisiana State University and is a Certified Public Accountant in the state of Florida. Mr. Fellows has published numerous articles in professional tax journals, and his research interests include the taxation of small businesses and the taxation of real estate.
1. The Revenue Reconciliation Act of 1990 is codified as Public Law 101-58, and amends the Internal Revenue Code, Title 26, U.S. Code.
2. See, for example, N. Oestreich, H. Toole, and O. Gailbraith, "Restoring the Incentive for the Elderly to Work," Tax Notes (October 22, 1990): 469-471; J.R. Gist and J. Mulvey, "Marginal Tax Rates and Older Taxpayers," Tax Notes (November 5, 1990): 679-694; G. Brannon, "Should I Work in 1991?" Tax Notes (January 14, 1991): 189-190.
3. D.D. Bensinger, H.M. Savage, and R.J. Shaffer, "Marginal Tax Rates of Self-Employed Taxpayers," Tax Notes (August 19, 1991): 957-964. For 1992 and later years these amounts are adjusted for inflationary factors.
4. Capital assets are defined by Section 1221 of the code as "property held by the taxpayer (whether or not connected with his trade or business)," exclusive of six categories of items that are not capital assets. The most notable excluded categories include: 1) property held primarily for sale to customers in the ordinary course of trade or business; 2) copyrights, literary or musical compositions, or similar properties; and 3) accounts receivable. Typical capital assets include real property, stocks, and bonds.
5. More specifically, in President Bush's January 28, 1992, "State of the Union" address, the White House proposed a reduction in capital gains tax to effective maximum rates of 15.4% for assets held at least 3 years; 19.6% for assets held between 2 and 3 years; and 23.8% for assets held between 1 and 2 years. These effective maximum rates are calculated by multiplying the maximum ordinary income tax rate of 28% by 1 minus the exclusion amount. Assets held for at least 3 years would qualify for a 45% exclusion from tax; those held for between 2 and 3 years would qualify for a 30% exclusion; and those held between 1 and 2 years would qualify for a 15% exclusion from gross income.
6. This information was summarized by Representative Alex McMillan of North Carolina in a report to his colleagues in the U.S. House of Representatives, printed in The Charlotte Observer (December 16, 1991): 8A. Statistical information and averages pertaining to 1989 individual tax returns are reported in the Internal Revenue Service's SOI Bulletin (Spring 1991): 16-21.
7. In a related paper, "A Reconsideration of Effective Marginal Tax Rates after Recent Tax Reform," Taxes (April 1992): 260-270, the authors examine effective ordinary income marginal tax rates triggered by the phase-out deduction and personal exemption provisions in the Revenue Reconciliation Act of 1990.
8. See also Jerrold J. Stern, "Real Estate and the 1990 Tax Act" (College Station, Texas: The Real Estate Research Center, Texas A&M University, 1991).
9. In 1991, the 31% ordinary income tax bracket begins at taxable income levels of $49,300 for a single taxpayer, at $70,450 for a head of household, at $41,075 for a married couple filing separately, and at $82,150 for a married couple filing jointly.
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|Author:||Johnson, Linda L.; Fellows, James A.|
|Date:||Jan 1, 1993|
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