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Taxation of Capital Gains

Many taxpayers are confused when it comes to the taxation of capital gains, and for good reason! In order to comprehend this concept, you’ll need a general understanding of the following: (a) an asset’s holding period, (b) the “netting” rules, (c) ordinary and preferential tax rate schedules, and (d) the 3.8% Net Investment Income Tax. While this may seem overwhelming, answering the following three questions should clear up much of the confusion:

  1. How do the “netting” rules work for short-term and long-term capital gains and losses?
  2. How do I determine whether my capital gains will be taxed at 0%, 15%, 20%, or my ordinary income tax rate?
  3. Will my capital gains be subject to the 3.8% Net Investment Income Tax (NIIT)?
Let’s consider each question in turn.

How do the “netting” rules work for short-term and long-term capital gains and losses?

First, you’ll need to understand the difference between short-term and long-term gains/losses. The difference depends on the underlying asset’s holding period. If an asset is held for one year or less before it is sold, the resulting gain or loss is short-term. If the asset is held for more than one year before it is sold, the resulting gain or loss is long-term.

At the conclusion of the tax year, short-term gains are netted with short-term losses, and long-term gains are netted with long-term losses. Consider the following example:

Trade Gain/(Loss) Short-Term | Long-Term
1 $10,000 Short-Term
2 ($5,000) Short-Term
3 ($15,000) Long-Term
4 $8,000 Long-Term
Net Short-Term Gain/Loss: $5,000
Net Long-Term Gain/Loss: ($7,000)

The final step is to combine the net short-term gain/loss with the net long-term gain/loss. Continuing with the example above, this would result in a capital loss for the year of $2,000. This $2,000 loss is used to offset the taxpayer’s other taxable income. Keep in mind, the maximum allowable capital loss in any given tax year is $3,000. Any amount of capital loss in excess of $3,000 is carried forward to subsequent tax years indefinitely until the full amount is utilized by the taxpayer.

How do I determine whether my capital gains will be taxed at 0%, 15%, 20%, or my ordinary income tax rate?

Short-term and long-term capital gains are taxed differently. Short-term gains are taxed as ordinary income at rates ranging from 10% to 37%, depending on the taxpayer’s total taxable income.* Long-term capital gains (along with qualified dividends) are taxed at preferential rates, according to the table below.

Tax Rate Married Filing Joint & Surviving Spouses Single
Taxable Income
Minimum Maximum Minimum Maximum
0% $80,800 $40,400
15% $80,801 $501,600 $40,401 $445,850
20% $501,601 $445,851


To determine which rate will apply to your capital gains, follow the steps in the graphic below and consider the following example:

How to determine tax liability

Step 1 – Calculate adjusted gross income (AGI). This includes all taxable income less “above-the-line” adjustments (not to be confused with itemized deductions).
 
Step 2 – Calculate Ordinary Income.
Ordinary Income = AGI - (Long-Term Capital Gains + Qualified Dividends)
 
Step 3 – Calculate Net Ordinary Income.
Net Ordinary Income = Ordinary Income - The Greater of the Applicable Standard Deduction or Itemized Deductions
 
Step 4 – Calculate ordinary income tax by applying the applicable ordinary income tax rate schedule to net ordinary income.
 
Step 5 – Calculate capital gains tax by applying the applicable capital gains tax rate schedule to long-term capital gains and qualified dividends.

Remember: Both ordinary income and capital gains tax rate schedules are progressive. Net ordinary income fills up the lower tax brackets, then long-term capital gains and qualified dividends are stacked on top. The initial capital gains tax rate is based on where net ordinary income ends. Long-term capital gains and qualified dividends can advance the capital gains tax rate to the next bracket.

* Ordinary income tax rate schedules and standard deductions can be found in our separate piece, “2021 Quick Tax Facts.”

Example: How to Determine Tax Liability

Step 1 – In 2021, Luke and Rae have the following income:

Retirement Income: $100,000
Short-Term Capital Gains: $2,800
Long-Term Capital Gains: $10,000

Their adjusted gross income is $112,800.
 
Step 2 – Luke and Rae’s ordinary income is $102,000.

($112,800 - $10,000 = $102,800)
 
Step 3 – Luke and Rae are both over age 65, so their standard deduction is $27,800.* Therefore, their net ordinary income is $75,000.

($102,800 - $27,800 = $75,000)
 
Step 4 – Luke and Rae figure their ordinary income tax by applying the relevant 2021 income tax table* to their $75,000 of net ordinary income. Their ordinary income tax liability is $8,602.

($1,990 + 12% of the amount over $19,900 = $8,602)
 
Step 5 – Finally, Luke and Rae determine their long-term capital gains tax liability by applying the capital gains tax table (provided above) to their $10,000 long-term capital gain. In order to apply the correct rates, they must pick up where net ordinary income left off. Because their net ordinary income was $75,000, the first $5,800 (from $75,000 to $80,800) of their $10,000 long-term capital gain is taxed at 0%. The remaining $4,200 of their long-term capital gain is taxed at 15% for total capital gains tax liability of $630.

Luke and Rae’s tax bill, including ordinary income tax and capital gains tax, totals $9,232.


Will my capital gains be subject to the 3.8% Net Investment Income Tax (NIIT)?

You will be subject to the NIIT if you have net investment income and have modified adjusted gross income in excess of the applicable threshold ($250,000 for married taxpayers filing jointly and $200,000 for single taxpayers). The 3.8% NIIT will be imposed on the lesser of (a) your net investment income or (b) your excess modified adjusted gross income over the applicable threshold.

Let’s repeat steps one through five to account for a modification to our previous example. We will include an additional sixth step to calculate the NIIT.

Example: How to Determine Tax Liability with NIIT

Step 1 – Luke and Rae still have $100,000 of retirement income, $2,800 in short-term capital gains, and $10,000 in long-term capital gains. Additionally, they decide to sell their family business and thereby realize an additional long-term capital gain of $500,000. Their adjusted gross income is $612,800.
 
Step 2 – Luke and Rae’s ordinary income is still $102,000.
 
($612,800 - $510,000 = $102,800)
 
Step 3 – Luke and Rae take the same standard deduction of $27,800. Their net ordinary income is still $75,000.
 
($102,800 - $27,800 = $75,000)
 
Step 4 – Luke and Rae’s ordinary income tax remains at $8,602.
 
($1,990 + 12% of the amount over $19,900 = $8,602)
 
Step 5 – Luke and Rae apply the capital gains tax table to their $510,000 long-term capital gain. Again, they pick up where their ordinary income left off – $75,000. The first $5,800 of their gain is taxed at 0%. The next $420,800 is taxed at 15% for a total of $63,120, and the remaining $83,400 is taxed at 20% for a total of $16,680. This brings the overall capital gains tax liability to $79,800.
 
Step 6 – Luke and Rae’s modified adjusted gross income is $612,800. The 3.8% NIIT will be imposed on the lesser of (a) their net investment income ($510,000) or (b) their excess modified adjusted gross income over the applicable threshold ($612,800 - $250,000 = $362,800). They will pay the 3.8% NIIT on $362,800 for total NIIT liability of $13,786.
 

Luke and Rae’s tax bill, including ordinary income tax, capital gains tax, and NIIT, comes out to $102,188.

* Ordinary income tax rate schedules and standard deductions can be found in our separate piece, “2021 Quick Tax Facts.”

The above are hypothetical scenarios for illustrative purposes only. Stifel compiled this information from numerous Internal Revenue Service (IRS) sources. Additional state and local taxes may apply. Do not rely on this information when making decisions with tax consequences. Stifel does not provide legal or tax advice. You should consult with your legal and tax advisors regarding your particular situation.

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