The new capital gains rules maze.
The capital asset transactions rules provided in the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSR-RA '98) and the Surface Transportation Revenue Act of 1998 (STRA '98) represent a quantum leap into complexity. While tax advisers commonly use software to calculate capital gains tax, a clear grasp of the concepts underlying the calculations is critical to providing adequate tax planning services. A review of amended Sec. 1(h) quickly reveals how challenging this objective may be.Background
Traditionally, capital asset and related tax provisions may have been considered to be of modest difficulty. In general, the individual taxpayer was required to (1) identify capital asset transactions; (2) separate them according to holding period (short-term or long-term); (3) combine them (by adding similar gains and similar losses together, or by netting the gains and losses against each other in step (2)); and (4) net them as either net short-term gain/loss or net long-term gain/loss. Any resulting excess of net long-term gain over net short-term loss was granted favorable tax treatment. For an excess of net long-term capital loss over net short-term capital gain, the individual taxpayer would forfeit a portion of the excess net long-term capital loss as a deduction.
The Tax Reform Act of 1986 repealed the favorable and unfavorable tax treatments applicable to capital gains transactions; consequently, the capital gains provisions became simpler.
Through the years, relatively simple amendments were enacted, providing more favorable tax treatment for capital gains. The Taxpayer Relief Act of 1997 (TRA '97) introduced a new level of complexity, encompassing multiple rates, multiple holding periods, multiple asset classifications, additional terms, additional combinations of classes of gain/loss and more tiers of possible benefits. Shortly thereafter, the TRA '97 was amended by the IRSRRA '98 and the STRA '98. Exhibit 1, above, summarizes Sec. 1(h) in a formula format; Exhibit 2, on p. 312, presents the current classification and netting process of major elements; and Exhibit 3, on p. 312, demonstrates a graphical approach to the calculation of the tax.
Exhibit 1: Summary of Sec.1(h) in formula format Sec. 1. Tax imposed. (h) Maximum Capital Gains Rate (1) Shall not exceed the sum of (A) a tax computed (at regular rates) ... on the greater of: (i) TI - NCG, or (ii) the lesser of: (I) TI taxed below 28%, or (II) TI -- Adjusted NCG [Adjusted NCG = NCG - (Unrecaptured Sec. 1250 gain + 28% gain)] [Unrecaptured Sec. 1250 gain - LTCG (not otherwise treated as OI) that would be treated as OI if Sec. 1250(b)(1) included all depreciation x 100% -- excess of (Sec. 1(h)(5)(B)losses over Sec. 1(h)(5)(A) gains)](*) [28% Gain = excess of Sec. 1(h)(5)(A) over Sec. 1(h)(5)(8)] [Sec. 1(h)(5)(A)= collectibles gain + SBS] [Sec. 1(h)(5)(B) = collectibles loss + NSTCL + LTCL carried] (B) 10% x the lesser of [Adjusted NCG or TI], not greater than the excess of: (i) TI that would otherwise be taxed below 28%, over (ii) TI -- Adjusted NCG (C) 20% x the lesser of [Adjusted NCG or TI] in excess of (8) above (D) 25% x the excess of: (i) the lesser of [Unrecaptured Sec. 1250 gain or NCG] over (ii) any excess of (I) the sum of (A) above + NCG, over (II) TI; and (E) 28% of TI in excess of the sum of amounts in (A),(B),(C) and (D) above Legend: LTCG = long-term capital gain 0I = ordinary income LTCL = long-term capital loss SBS = small business stock NCG = net capital gain TI = taxable income NSTCL = net short-term capital loss
(*) See discussion in text.
Exhibit 2: Capital Gains and Losses--1998 Netting Process STEP #1 STEP #2 Ordinary Income: Short-term Capital Gain If Net Short-Term Capital Gain, extend to STEP #5 Short-term Capital Loss (If Net Short-Term Capital Loss, add to 28% Loss below) 28% rate: Collectibles & SBS(1) If Net 28% Gain, extend to STEP #5 Coll., LTCL carried, NSTCL(2) (If Net 28% Capital Loss, continue offsetting) 25% rate: Unrecaptured Sec. 1250 Gain Unrecaptured Sec. 1250 Gain 10%/20% rate gain Long-Term Capital Gain Net Long-Term Capital Gain/Loss Long-Term Capital Loss STEP #3 STEP #4 STEP #5 If excess unrecaptured Sec. 1250 gain, extend to Step #5 (If excess 28% Capital Loss, continue offsetting) If excess 10%/20% Gain 10%/20% Gain (If excess 10%/20% Loss, may be deductible)
(1) Small business stock.
(2) Collectibles, long-term capital loss carried and net short-term capital loss.
Exhibit 3: Calculating the capital gains tax Single taxpayer Ordinary 28% rate tax brackets income and NSTCG gains Over $278,450 39.6% 28% >$128,100-$278,450 36% 28% >$61,400-$128,100 31% 28% >$25,350-$61,400 28% 28% 0-$25,350 15% 15% Single taxpayer Unrecaptured NLTCG tax brackets Sec. 1250 gain 10%/20% Over $278,450 25% 20% >$128,100-$278,450 25% 20% >$61,400-$128,100 25% 20% >$25,350-$61,400 25% 20% 0-$25,350 15% 10%
1. "Pour in" all of the ordinary income and NSTCG.
2. "Pour in" oil of the 28% rate gains.
3. "Pour in" all of the unrecaptured Sec. 1250 gains.
4. "Pour in" all of the NLTCG-10%/20% gains.
Starting at the bottom, calculate the tax on each "layer," or type of gain, at the rate indicated in the table. If there is no capital gain for any element, it is skipped; the next one listed substitutes into the position that would have been occupied by the element missing (see the example in the text).
Example: T had taxable income in 1998 of $30,350. T's taxable income consisted of $18,350 of ordinary income, $1,500 of short-term capital gain, a $2,500 short-term capital loss, a $3,000 collectibles gain, a $4,000 unrecaptured Sec. 1250 gain, a $6,400 long-term capital gain and a $400 long-term capital loss. The chart below shows the netting process.
Type of gain/loss Amount First netting Short-term capital gain $1,500 Net short-term capital loss of $1,000 Short-term capital loss 2,500 Collectibles gain 3,000 Net 28% gain of $3,000 Collectibles loss 0 Unrecaptured Sec. 1250 gain 4,000 $4,000 Long-term capital gain 6,400 Net long-term capital gain of $6,000 Long-term capital loss 400 Type of gain/loss Second netting Short-term capital gain 0 Short-term capital loss 28% gain = $2,000 Collectibles gain Collectibles loss Unrecaptured Sec. 1250 gain 25% gain = $4,000 Long-term capital gain 10%/20% gain = $6,000 Long-term capital loss
An overview of Sec. 1(h)(1) reveals the various components that constitute tiers (or layers) of taxation receiving favorable tax treatment as compared to ordinary income. Sec. 1(h)(1)(A) is the most complex, because it contains numerous complex calculations, many of which are new. For example, Sec. 1(h)(1)(A)(i) requires the calculation of the excess of taxable income over net capital gain. Sec. 1(h)(1)(A)(ii) elicits two figures--taxable income below the 28% marginal tax rate and the excess of taxable income over adjusted net capital gain. Here, significant difficulty is encountered because of the need to make adjustments to net capital gain. As indicated in Exhibit 1, adjusted net capital gain equals the excess of net capital gain over the sum of unrecaptured Sec. 1250 gain and 28% rate gain. Next, unrecaptured Sec. 1250 gain and 28% rate gain must be determined. Sec. 1(h)(7) defines "unrecaptured Sec. 1250 gain" as the excess of the amount of long-term capital gain (not otherwise treated as ordinary income) that would be treated as ordinary income if Sec. 1250(b)(1) included all depreciation and the applicable percentage under Sec. 1250(a) were 100% over the excess (if any) of (1) the amount described in Sec. 1(h)(5)03) over (2) the amount described in Sec. 1(h)(5)(A).
Clearly, the definition of unrecaptured Sec. 1250 gain places considerable complexity in the adviser's path. The definition may be more easily understood as all depreciation on a Sec. 1250 asset (less the amount recaptured) minus the excess of Sec. 1(h)(5)(B) losses over Sec. 1(h)(5)(A) gains. A Sec. 1(h)(5)(B) loss is collectibles loss, net short-term capital loss and long-term capital loss carried under Sec. 1212(b)(1)(B) to the tax year. Sec. 1(h)(5)(A) gain consists of collectibles gain and Sec. 1202 gain (on small business stock). The objective of Sec. 1(h) is to accord favorable marginal tax rates to the various components of net capital gains; accordingly, the statute must specifically circumscribe each element picked for a specified degree of favorable treatment.
Exhibit 2, above, is derived from Sec. 1(h) and shows diagrammatically how the combining and netting process serves to isolate the tiers (i.e., individual components) of capital asset transactions. In Exhibit 2, a net short-term capital loss is now combined with losses on collectibles and long-term capital losses "carried" to be offset against collectibles gains and small business stock gains, rather than against net long-term capital gains. (The line of dashes serves to guide the reader from each tier of gain to the column titled, "Step #5," which identifies tax treatment status as a prelude to calculation of the relevant tax.) Although the focus is on the treatment of the gains, losses inevitably occur. The treatment of losses in capital asset transactions is depicted in Exhibit 2's netting process, which offsets losses against gains in an order that first reduces gains that would be taxed at the highest marginal rates. Exhibit 2 facilitates the practitioner's ability to net items.
Finally, Exhibit 3 demonstrates the calculation of tax for each of the capital gain components. For this purpose, the 1998 tax rate schedule for unmarried taxpayers is used. The first step is to "pour in" all of the isolated ordinary income and any net short-term capital gain. The total of these two types of income will be taxed at ordinary income rates. If the taxable income is below $25,350, the difference represented by the distance between this total (ordinary income/short-term capital gain) and $25,350 is the maximum amount of 28% gains (if any) taxed at 15%. If the amount of 28% gains "poured-in" rises above $25,350, the maximum amount taxed at 15% is so taxed; all of the remaining 28% gains are taxed at 28%. If the sum of ordinary income and short-term capital gains (without the 28% gains) exceeds $25,350, all 28% gains will be taxed at 28%.
If there are no 28% gains, the maximum amount of 28% gains taxed at 15% becomes the maximum amount of unrecaptured Section 1250 gain (if any) taxed at 15%. If there are some 28% gains, that amount serves to reduce the unrecaptured Sec. 1250 gain taxed at 15%. Any unrecaptured Sec. 1250 gain that exceeds $25,350, when added to ordinary income, short-term capital gain and 28% gains, will be taxed at 25%. This process is also applied to any 10%/20% gain, and the absence of one or more of the capital gain types results in the substitution of the next one into the position that would otherwise have been taken by the missing type (see Exhibit 3).
The example, below, explains this calculation.
The "first netting" nets short-term gains and losses, a prerequisite for calculating the net 28% rate gain. The 28% gain after netting the net short-term capital loss is shown in the "second netting" column. This column also presents the amounts of the other tiers of capital gain elements. With these tiers isolated and the ordinary income component given, T's tax may be calculated. First, the tax on the first tier is $2,753 ($18,350 of ordinary income taxed at 15%). Next, the net 28% gain of $2,000 is added, raising the total to $20,350, which is still below 28%; this $2,000 tier is taxed at only 15%, for a supplemental $300 tax. Next, the $4,000 of unrecaptured Sec. 1250 gain is included, raising the total to $24,350, which is still below 28%. This $4,000 tier is also taxed at only 15%, for an additional $600 tax. Finally, the $6,000 of 10%/20% gain is poured in, raising the total to $30,350. Before adding this tier, $1,000 remained available for taxation at 15% ($25,350 -- $24,350). Therefore, two different tax rates apply to this gain tier. The first $1,000 of the $6,000 gain is taxed at 10%, rather than 15%. This $1,000 of 10%/20% gain will be taxed at 10% for an additional $100 tax. The remaining $5,000 extends above the $25,350 demarcation line between the 25% and 28% rates. However, under Sec. 1(h)(1)(C), this component is taxed at only 20%, yielding an additional $1,000 tax. The only step remaining is to sum the tax computed on each tier of income to determine the total tax liability; the total is $4,753 ($2,753 + $300 + $600 + $100 + $1,000).
Conclusion
Recently amended Sec. 1(h) launches a new era for the tax accounting of capital gains transactions and presents a maze of provisions that may confound the tax practitioner. However, by breaking down the Sec. 1(h) provisions into several components, a logical approach may be devised. The exhibits contained herein provide the practitioner with tools that not only aid in understanding the new rules, but also assist in the mechanical application of the required calculations.
FROM FRANK E. WATKINS, JR., CPA (INACTIVE),J.D., PH.D., AND KATHERINE O. WILBURN, J.D., INSTRUCTOR, UNIVERSITY OF ALABAMA AT BIRMINGHAM, BIRMINGHAM, AL3
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| Author: | Wilburn, Katherine O. |
|---|---|
| Publication: | The Tax Adviser |
| Geographic Code: | 1USA |
| Date: | May 1, 1999 |
| Words: | 2295 |
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