Section 1211(b) provides that a taxpayer other than a corporation 1 may claim capital losses only to the extent of capital gains plus the lesser of $3000 or the excess of such losses over gains. This is one of very few places in the Code where taxpayer may mismatch what might be NLTCL against income subject to ordinary income rates, whether STCG or otherwise.
In the event taxpayer incurred losses greater than those allowed by § 1211(b), i.e., a “net capital loss, § 1222(10), taxpayer may carry them forward until he/she dies. § 1212(b). Section 1212(b) treats a capital loss-carryover as if it were one of the transactions described in §§ 1222(3 or 4) in the next succeeding year.
- The Code creates a pecking order of capital loss carryovers by requiring taxpayer – before calculating his/her capital loss carryovers – to add a (hypothetical) STCG equal to the lesser of taxpayer’s § 1211(b) deduction or taxpayer’s “adjusted taxable income.” § 1212(b)(2)(A). 2
- If the “net capital loss” results from NLTCL and NSTCL, the taxpayer first reduces the NSTCL by the amount of his/her § 1211(b) deduction, second reduces the NLTCL by the balance (if any) of his/her § 1211(b) deduction. Taxpayer carries forward all of the NLTCL and reduces the NSTCL by the amount deducted. § 1212(b)(2)(A).
- If NSTCL > NLTCG, taxpayer carries forward the “net capital loss” as a STCL transaction. § 1212(b)(1)(A) and § 1212(b)(2)(A).
- If NLTCL > NSTCG, taxpayer carries forward the “net capital loss” as a LTCL transaction. §§ 1212(b)(1)(B) and 1212(b)(2)(A).
Example 1: Taxpayer has $100,000 of ordinary income. Taxpayer does his/her § 1222 calculations. For the tax year, taxpayer has $5000 of NSTCL and $4000 of NLTCL. What is taxpayer’s § 1211(b) deduction, and what is taxpayer’s § 1212(b) capital loss carryover?
- Taxpayer’s capital losses exceed his/her capital gains by $9000. Taxpayer’s § 1211(b) deduction is $3000. Taxpayer’s “net capital loss” (§ 1222(10)) is $6000.
- We calculate taxpayer’s capital loss carryovers by first adding $3000 (the amount of taxpayer’s § 1211(b) deduction) to his/her NSTCL. Taxpayer’s NSTCL becomes $2000; taxpayer’s NLTCL is $4000. Taxpayer will carry these amounts forward. In the succeeding year, taxpayer will include $2000 as a STCL and include $4000 as a LTCL.
2. Taxpayer has $100,000 of ordinary income. Taxpayer does his/her § 1222 calculations. For the year, taxpayer has $7000 of NSTCL and $2000 of NLTCG.
- Taxpayer’s capital losses exceed his/her capital gains by $5000. Taxpayer’s § 1211(b) deduction is $3000. Taxpayer’s “net capital loss” is $2000.
- We calculate taxpayer’s capital loss carryover by first adding $3000 to his/her NSTCL. Taxpayer’s NSTCL becomes $4000. Taxpayer will carry this amount forward. In the succeeding year, taxpayer will include $4000 as a STCL.
Dividends
For many years, dividend income that individual taxpayers received was taxed as ordinary income. Dividend income comes from corporate profits on which the corporation pays income tax. The corporation may not deduct dividends that it pays to shareholders. Hence, dividend income that a shareholder actually receives is subject to two levels of income tax. This double tax has been subject to criticism from the beginning. Nevertheless, it is constitutional. A legislative compromise between removing one level of tax and retaining the rules taxing dividends as ordinary income is § 1(h)(11). An individual adds “qualified dividend income” to his/her net capital gain. § 1(h)(11)(A). “Qualified dividend income” includes dividends paid by domestic corporations and by “qualified foreign corporations.” § 1(h)(11)(B)(i). A “qualified foreign corporation” is one incorporated in a possession of the United States or in a country that is eligible for certain tax-treaty benefits, or one whose stock “is readily tradable on an established securities market in the United States.” § 1(h)(11)(C).
The effect of treating dividend income as “net capital gain” is to subject dividend income to the reduced rates that § 1(h) imposes on “net capital gain.” However, placement of this rule in § 1(h) means that capital losses do not offset dividend income.
3. Taxpayer has $100,000 of ordinary income. Taxpayer does his/her § 1222 calculations. For the year, taxpayer has $11,000 of NSTCG and $18,000 of NLTCL.
- Taxpayer’s capital losses exceed his/her capital gains by $7000. Taxpayer’s § 1211(b) deduction is $3000. Taxpayer’s “net capital loss” is $4000.
- We calculate taxpayer’s capital loss carryover by first adding $3000 to his/her NSTCG. Taxpayer’s NSTCG becomes $14,000. Subtract $14,000 from $18,000. Taxpayer will carry forward $4000 forward to the succeeding year as a LTCL. § 1212(b)(1)(B).
Matching the character of gains and losses: Aside from §§ 1211 and 1212, the Code strictly implements a matching regime with respect to ordinary gains and losses, and capital gains and losses. A taxpayer who regularly earns substantial amounts of ordinary income and incurs very large investment losses can use those losses only at the rate prescribed by § 1211(b) in the absence of investment gains. 3
Taxing Ordinary Income, “Net Capital Gain,” and “Adjusted Net Capital Gain”
Not all capital gain is taxed alike, but no capital gain income should be taxed at a rate higher than the rate applicable to a taxpayer’s ordinary income. To implement this principle, § 1(h) establishes various maximum rates. The highest maximum rate is the rate on ordinary income. In the event that taxpayer’s circumstances qualify different forms of capital gain income to a lower maximum rate, then, and only then, that lower maximum rate applies. Otherwise the ordinary income rate applies.
Section 1(h) distinguishes between “net capital gain” and “adjusted net capital gain.” Section 1(h)(3) defines the phrase “adjusted net capital gain” to be “net capital gain” MINUS “unrecaptured § 1250 gain,” MINUS “28-percent rate gain,” PLUS “qualified dividend income.” There are different maximum rates applicable to taxpayer’s “adjusted net capital gain” that depend on what taxpayer’s marginal bracket would be if all of his/her taxable income were subject to tax as ordinary income. Those maximum rates (0%, 10%, 20%) are applicable only if they are lower than the marginal rate otherwise applicable to taxpayer’s taxable income taxed as ordinary income. The maximum tax rates on unrecaptured § 1250 gain is 25%, and the maximum tax rate on 28% rate gain is 28%.
Do the CALI Lesson Basic Federal Income Taxation: Property Transactions: Capital Loss Mechanics
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