We already know that § 1 imposes income taxes on individuals. 1 Section 1(h) creates income “baskets” that are subject to different maximum rates of income tax (see text box). Once an income “basket” has been subject to a particular maximum rate of tax, the principle that we tax income once applies.
Section 1(h) refers to “net capital gain,” which we determined under § 1222 by netting gains and losses from sales or exchanges of various capital assets. Section 1(h) supplies more definitions, most of which refine the concept of “net capital gain.” The importance of placing definitions in § 1(h) rather than adding another sub-section to § 1222 is that the particular definition only applies to individuals 2 – not to corporations.
Sections 1(h)(1)(B, C, D, E, and F) impose different maximum rates of tax on different forms of “net capital gain.” These rates are dependent on the rate of tax imposed on a taxpayer’s ordinary income – viz., they increase when a taxpayer’s marginal rate on ordinary income reaches 25% and increase again when a taxpayer’s marginal rate on ordinary income reaches 39.6%. In addition, there is a medicare “contribution” of 3.8% on the unearned income of (relatively 3) high income earners. § 1411. [Thus the net of federal taxes on the long-term capital gains of some taxpayers is 18.8% or 23.8%, not 15% of 20%.]
Unrecaptured § 1250 gain and 28-percent rate gain
“Unrecaptured § 1250 gain” is the income attributable to recapture of depreciation that taxpayer has claimed on real property. It will be included in taxpayer’s net § 1231 gain. “28-percent rate gain” property is the net of collectibles gains and losses PLUS § 1202 gain, i.e., half of the gain from the sale of certain small business stock held for more than five years. § 1(h)(4). Temporarily, none of the gain from the sale of such stock was included in “28-percent rate gain.” A “collectible” is essentially any work of art, rug or antique, metal or gem, stamps or certain coins, an alcoholic beverage, and anything else that the Secretary of the Treasury designates. § 408(m)(2).
Section 1(h)(1)(A) isolates “ordinary income” 4 and subjects it to the progressive tax brackets of § 1(a). 5 Section 1(h)(1)(A) also assures that the “net capital gain” of a taxpayer is subject to the lower rates of tax on only so much of the gain otherwise necessary for a taxpayer’s total taxable income to reach the 25% bracket.
The next “basket” of income is “adjusted net capital gain” (see accompanying box). Section 1(h)(1)(B) subjects the “adjusted net capital gain” of a taxpayer whose marginal rate on ordinary income is less than 25% to a 0% tax. If a taxpayer’s ordinary income plus “adjusted net capital gain” is less than the 25% bracket threshold, to that extent the elements that distinguish “adjusted net capital gain” from “net capital gain” (see accompanying box) are subject to tax at ordinary income rates.
Section 1(h)(1)(C) subjects the “adjusted net capital gain” of taxpayers whose marginal rate on ordinary income is 25% or more to a tax rate of 15%. Section 1(h)(1)(D) subjects the “adjusted net capital gain” of taxpayers whose marginal rate on ordinary income is 39.6% to a tax rate of 20%. Section 1(h)(1)(E) subjects unrecaptured depreciation on real property up to the amount of net § 1231 gain to a maximum rate of 25%. Section 1(h)(1)(F) subjects “28-percent rate gain” property to a maximum rate of (surprise) 28%.
Taxpayer’s tax liability is the sum of the taxes imposed on these income baskets.
Do the CALI Lesson Basic Federal Income Taxation: Property Transactions: Capital Gain Mechanics (Do not worry about the questions on “capital gain net income”).