The Difference Between Capital Gains and Ordinary Income

Most long-term capital gains are taxed at 15% for 2010. This rate is scheduled to increase to 20% in 2011. Unfortunately, we need to say "most" because there are some exceptions as follows:

Taxpayers in the 10% and 15% ordinary bracket-0%
Certain depreciation recapture on real estate-25%
Collectibles-28%

A long-term gain is from the sale of a capital asset held longer than a year. A capital asset includes stocks, bonds, mutual funds, and real estate (other than residence).

Short-term gains are those that are held one year or less. Short-term gains are taxed at ordinary income tax rates. Ordinary income tax brackets for married couples filing joint for 2010 are projected as follows:

Taxable Income Tax Rate

0€-16,750 - 10%
16,750€-68,000 - 15%
68,000€-137,300 - 25%
137,300€-209,250 - 28%
209,250€-373,650 - 33%
Over 373,650 - 35%

The highest ordinary income tax bracket is also scheduled to increase in 2011 to 39.6%.

Capital gains and losses are netted against each other. If this results in a net loss, this loss is limited to a $3,000 tax deduction for a married couple filing a joint return. Any loss above this is carried into future years.

However, be cautious. Some taxpayers may be subject to an Alternative Minimum Tax ("AMT"). Taxpayers need to calculate their income two ways. First, calculate the income tax under the regular method, and second, under the AMT method. Then pay the higher of the two taxes. For taxpayers subject to the AMT, it may make their effective tax rate on long-term capital gains higher than the stated rate of 15%.

It is important to know the holding period for any capital assets and whether the sale will result in a gain or loss.

Thomas F. Scanlon, CPA, CFP.

Is Ordinary Income Different From Capital Gains?

Earned income (typically from employment) is considered ordinary income. In 2009, ordinary income tax rates range from 10 to 35 percent. An individual's marginal tax rate is the percent of the last dollar made during the year that must go towards taxes. It's important to note that a taxpayer's marginal tax rate is not applied to every dollar earned during the year. Examine the following chart, which illustrates the federal tax schedule for married individuals filing jointly in 2009.

o 10% on the income between $0 and $16,700
o 15% on the income between $16,700 and $67,900; plus $1,670
o 25% on the income between $67,900 and $137,050; plus $9,350
o 28% on income between $137,050 and $208,850; plus $26,637.50
o 33% on income between $208,850 and $372,950; plus $46,741.50
o 35% on the income over $372,950; plus $100,894.50

As the chart indicates, all income up to $16,700 will be taxed at 10 percent, and only income between $16,700 and $67,900 will be taxed at 15%. This layering of tax rates creates a distinction between a taxpayer's marginal and effective tax rates. If a couple earned $75,000 in a year, they would be in the 25 percent marginal tax bracket, but their actual federal tax bill would be $11,125 (calculated by subtracting $67,900 from $75,000 and multiplying the result by 25 percent, then adding $9,350). Thus, the couple's effective federal tax rate would be 14.83 percent ($11,125 divided by $75,000).

Marginal rates are used to calculate how much tax can be saved by increasing deductions. A taxpayer in the 25 percent marginal tax bracket will save 25 cents in federal tax for every dollar spent on a tax-deductible expense, such as mortgage interest.

Capital gains tax is applied to most items purchased and sold for investment purposes. For the purposes of this writing, the items most applicable to capital gains taxes are stocks, bonds, money market accounts, and property. When a capital asset is sold, the difference between the selling price and the basis (usually what was paid for the asset plus the costs of any improvements made) is subject to capital gains tax.

Capital gains or losses are further classified as short-term and long-term. An asset that was owned for 12 months or less is considered to be a short-term asset, and any gains from the sale of short-term assets are taxed at ordinary income rates. Long-term assets are owned for more than 12 months, and qualify for taxation at favorable capital gains tax rates.

Capital gains tax rates are lower than ordinary income rates in order to give investors an incentive to invest in the economy. In 2009, taxpayers in the 10 or 15 percent marginal tax brackets qualify for the generous capital gains tax rate of 0 percent, while taxpayers who are in the 25 percent or higher marginal tax brackets pay a capital gains tax of 15 percent.

Your financial planning efforts should always consider tax implications. Recruit an independent fee only financial planner who prefers to work closely with your tax preparer.