8606 / How is net capital gain taxed?

If a taxpayer has net capital gain for any tax year, the IRC provides that the tax will not exceed the sum of the following six items:

(A)   the tax computed at regular rates (without regard to the rules for capital gain) on the greater of (i) taxable income reduced by the net capital gain, or (ii) the lesser of (I) the amount of taxable income taxed at the rates that apply if taxable income is below the relevant income threshold (see Q 8605), or (II) taxable income reduced by the adjusted net capital gain;

(B)   0 percent of the taxpayer’s adjusted net capital gain (or, if less, taxable income) that does not exceed the excess (if any) of (i) the amount of taxable income that would (without regard to this paragraph) be taxed at the rates that apply if taxable income is below the relevant income threshold (see Q 8605) over (ii) the taxable income reduced by the adjusted net capital gain;

(C)   15 percent of the lesser of (i) so much of the taxpayer’s adjusted net capital gain (or, if less, taxable income) as exceeds the amount on which a tax is determined under (B), above, or (ii) the excess of (I) the amount of taxable income which would be taxed at the rates that apply if taxable income is below the relevant income threshold (see Q 8605) over (II) the sum of the amounts on which a tax is determined under (A) and (B), above;

(D)   20 percent of the taxpayer’s adjusted net capital gain (or, if less, taxable income) in excess of the sum of the amounts on which tax is determined under (B) and (C), above;

(E)  25 percent of the excess (if any) of (i) the unrecaptured IRC Section 1250 gain (or, if less, the net capital gain (determined without regard to qualified dividend income)), over (ii) the excess (if any) of (I) the sum of the amount on which tax is determined under (A) above, plus the net capital gain, over (II) taxable income (see Q 8607 for a discussion of unrecaptured IRC Section 1250 gain); and

(F) 28 percent of the amount of taxable income in excess of the sum of the amounts on which tax is determined under (A) through (D) above. See Q 8607 for a discussion of 28 percent gain.

For most long-term capital gains, this complicated formula generally results in a maximum capital gains rate on adjusted net capital gain equal to 20 percent, 15 percent, or 0 percent, depending upon income level. Note that under the 2017 tax reform legislation, these thresholds no longer neatly align with the ordinary income tax brackets.

1.  IRC § 1222(11).

2.  IRC §§ 163(d)(4)(B)(iii), 1(h)(2).