by Bob Rywick
Short-term capital losses (including any short-term carryover) of non-corporate taxpayers (individuals, estates and trusts) are applied first to reduce short-term capital gains. Under Internal Revenue Code §1(h)(4) and IRC §1(h)(6), a net short-term capital loss is then applied to reduce net long-term capital gain in the following order:
● First, to reduce long-term capital gain taxed at a maximum rate of 28 percent (collectibles gain and Section 1202 gain); then,
● To reduce unrecaptured Section 1250 gain, i.e., gain taxed at a maximum rate of 25 percent; and then,
● To reduce adjusted net capital gain (taxed at a maximum rate of 15 percent if taken into account after May 5, 2003, and taxed at a maximum rate of 20 percent if taken into account before May 6, 2003).
While adjusted net capital gain includes qualified dividend income for purposes of determining the maximum tax rate on adjusted net capital gain, qualified dividend income is not included in adjusted net capital gain for purposes of using capital losses to offset adjusted net capital gain.
Example 1: In the tax year ending Dec. 31, 2002, your client had net capital gain of $60,000, consisting of a net short-term loss of $40,000 and a net long-term capital gain of $100,000. Her net long-term capital gain included collectibles gain of $20,000 in the 28 percent group, unrecaptured Section 1250 gain of $30,000 in the 25 percent group, and adjusted net capital gain of $50,000.
Your client’s net short-term capital loss is first used to completely offset the collectibles gain of $20,000, and is then used to offset $20,000 of the unrecaptured Section 1250 gain of $30,000. No part of the short-term capital loss is available to offset any of the adjusted net capital gain of $50,000.
Effect of transitional rule for tax years that include May 6, 2003, on use of net short-term capital loss to offset net long-term capital gain. As noted above, IRC §1(h)(4) and IRC §1(h)(6) provide that a net short-term capital loss for a tax year (including a net short-term capital loss carried over from a prior year) is first used to offset 28 percent rate gain, and then is used to offset unrecaptured Section 1250 gain.
It is used to offset adjusted net capital gain only to the extent that the total net short-term capital loss exceeds the sum of the 28 percent rate gain and the unrecaptured Section 1250 gain.
However, under Section 301(c)(2) of the Jobs and Growth Tax Relief Reconciliation Act of 2003, the adjusted net capital gain taxed at a 5 percent or 15 percent rate equals the net capital gain taken into account for the part of the tax year after May 5, 2003 (determined without regard to collectibles gain or loss, unrecaptured Section 1250 gain and Section 1202 gain).
This seems to mean that the net short-term capital loss for the period after May 5, 2003, must be subtracted from the net long-term capital gain (other than 28 percent rate gain and unrecaptured Section 1250 gain) to get adjusted net capital gain taxed at the 5 percent or 15 percent rates. Thus, there seems to be a conflict between what the code requires and what the act provides.
Observation: If the entire net short-term capital loss arose before May 6, 2003, there is no problem.
Example 2: The same facts apply as in Example 1, except that the tax year ends Dec. 31, 2003, and all of the net short-term capital loss arose before May 6, 2003. The result is the same. Your client’s net short-term capital loss is first used to completely offset the collectibles gain of $20,000, and is then used to offset $20,000 of the unrecaptured Section 1250 gain of $30,000. No part of the short-term capital loss is available to offset any of the adjusted net capital gain of $60,000.
Observation: The Jobs and Growth Act provision is designed to prevent net short-term capital loss taken into account after May 5, 2003, from being used to offset adjusted net capital gain taken into account before May 6, 2003. Without this provision, the rest of the transitional rule for taxing adjusted net capital gain in a year that includes May 6, 2003, would result in a post-May 5, 2003, net short-term capital loss offsetting adjusted net capital gain taxed at the highest rate before being used to offset adjusted net capital gain taxed at a lower rate.
Observation: The Jobs and Growth provision works fine as long as there is no 28 percent rate gain or unrecaptured Section 1250 gain for the tax year that includes May 6, 2003. However, if there is long-term capital gain other than adjusted net capital gain, there can be a very strange result. Schedule D to the 2003 Form 1040, and the related worksheets contained in the instructions, allow such a post-May 5, 2003, net short-term capital loss to reduce both 28 percent rate gain (with any excess of the loss used to reduce unrecaptured Section 1250 gain) as well as to reduce post-May 5, 2003, adjusted net capital gain. This doesn’t result in a reduction in either total net capital gain or total adjusted net capital gain, but can have the strange effect of having some post-May 5, 2003, adjusted net capital gain taxed at pre-May 6, 2003, rates (20 percent or 10 percent instead of 15 percent or 5 percent).
Example 3: Your client, a single taxpayer, has taxable income of $60,000 in his tax year ending Dec. 31, 2003. This taxable income includes $25,000 of ordinary taxable income, $10,000 of qualified dividends, and net capital gain (other than qualified dividends) of $25,000, consisting of the following:
● $5,000 of post-May 5, 2003, net short-term loss. Your client has no items of short-term capital loss for the part of his 2003 tax year before May 6, 2003;
● $20,000 of post-May 5, 2003, items taken into account in determining adjusted net capital gain (exclusive of qualified dividends). Your client has no pre-May 6, 2003, items that are taken into account in determining adjusted net gain; and,
● $10,000 of collectibles gain.
The net capital gain of $25,000 (exclusive of qualified dividends) equals $25,000 (the sum of $20,000 of post-May 5, 2003, adjusted net capital gain and $10,000 of collectibles gain), less the $5,000 of net short-term capital loss. This net capital gain of $25,000 is shown on Line 17a of Schedule D.
The total adjusted net capital gain (again before including qualified dividends) equals the net capital gain less the net collectibles gain. What is the net collectibles gain? According to the code and the 28 Percent Rate Gain Worksheet on p. D-8 of the Instructions to Schedule D to 2003 Form 1040, it would be $5,000 (total collectibles gain of $10,000, less net short-term capital loss of $5,000). Thus, the total adjusted net capital (exclusive of qualified dividend income) is $20,000 (net capital gain of $25,000, less net collectibles gain of $5,000).
What is the total post-May 5, 2003, adjusted net capital gain (exclusive of qualified dividends)? According to Jobs and Growth Sec. 301(c)(2), and Line 17b of Schedule D to 2003 Form 1040, it is the post-May 5, 2003, items taken into account in determining adjusted net capital gain ($20,000), less the net short-term capital loss of $5,000. Thus, the post-May 5, 2003, adjusted net capital gain (exclusive of qualified dividends) is $15,000. After adding the qualified dividend income to adjusted net capital gain, you have total adjusted net capital gain of $25,000.
This means that, according to Schedule D and its accompanying worksheets, the net short-term capital loss is deducted both in determining 28 percent rate gain (collectibles gain in this example) and in determining post-May 5, 2003, adjusted net capital gain. The net short-term capital loss is deducted only once, however, in determining total net capital gain and total adjusted net capital gain. As a result, $5,000 of the total adjusted net capital gain is treated as pre-May 6, 2003, adjusted net capital gain even though all the items taken into account in determining adjusted net capital gain are post-May 5, 2003, items.
Your client’s total federal income tax for 2003 based on the above would be $9,108, i.e., the sum of the following:
● $700 (10 percent of ordinary taxable income of $7,000);
● $2,700 (15 percent of his ordinary taxable income of $18,000);
● $510 (15 percent of collectibles gain of $3,400, i.e., $28,400 (the amount of taxable income taxed at a rate under 25 percent), less ordinary taxable income of $25,000 taxed at a rate under 25 percent);
● $3,750 (15 percent of post-May 5, 2003, adjusted net capital gain of $25,000 (including qualified dividends));
● $1,000 (20 percent of pre-May 6, 2003, adjusted net capital gain of $5,000 as computed on Schedule D and its accompanying worksheets, even though there are no items taken into account before May 6, 2003, in determining adjusted net capital gain); and,
● $448 (28 percent of collectibles gain of $1,600 (net collectibles gain of $5,000, less collectibles gain of $3,400 that is taxed at a rate of 15 percent as shown above)).
Observation: If, in Example 3, all of your client’s adjusted net capital gain was treated as post-May 5, 2003, adjusted net capital gain, it would be taxed at 15 percent, instead of having $5,000 taxed at a rate of 20 percent. If that had happened, then your client’s total tax would have been $250 lower, or $8,858 instead of $9,108.
A rule that was apparently designed to prevent a post-May 5, 2003, net short-term loss from being used to offset pre-May 6, 2003, adjusted net gain has the effect of converting some post-May 5, 2003, adjusted net gain into pre-May 6, 2003, adjusted net capital gain in situations if (and only if) a non-corporate taxpayer has 28 percent rate gain and/or unrecaptured Section 1250 gain.
This result seems so strange that I would like to hear from any subscribers who believe that I have misinterpreted the rules and the instructions to Schedule D to Form 1040 in making the computation set out in Example 3, above.
