How US federal long term capital gains taxes are calculated
This is the text transcript of this video. It also includes the slides used in the video above.
This is the second part of this two-part video series on long-term capital gains taxes.
This is Larry Russell. This is a second of two videos that I’m doing on how US federal long term capital gains taxes are calculated. In this second video I am going to go over a tax forms example that I made up.
In the first video, I went over conceptually how long term capital gains taxes are taxed for both people that are single or married couples filing jointly. I will review that in a moment but first let me construct the example.
In this particular case, we are talking about a retired couple that have a larger family home that they no longer need, and they already own a vacation home. What they going to do is to sell their family home and not by another replacement home. Instead, they will downsize into the vacation home that they already own.
What will end up happening is that total taxable income using 2016 tax rates will show up on Form 1040 as $140,000. This hundred forty thousand dollars will be composed of $35,000 worth of net taxable ordinary income, plus $100,000 of long term capital gains, plus $5,000 worth of qualified dividends.
I am now going to summarize a few points about this ordinary income. In reality, they actually have $55,600 of ordinary taxable income sources such as wages salaries, etc. But subtracted from that, there are two personal exemptions which would be $8,000. In this case, I am also reducing the taxable income amount by the standard deduction of $12,600 which would be applicable with 2016 rates.
This point is made here simply because in some circumstances people might have itemized deductions that are a lot higher. Higher deductions would have the effect of reducing the amount of actual taxable ordinary income, that would affect the long-term capitals gains taxation process. But, in this particular case, we are going to use the 2016 standard deduction for a married couple filing jointly and will have $35,000 worth of taxable ordinary income that would be subject to ordinary graduated income tax rates.
In this long term capital gains taxes column we are going to assume that the home that they sell will have net sales proceeds of $750,000 after sales costs. Now many years ago, they acquired this house for $150,000 and that is the tax basis for the house. So, the difference between these two amounts is $600,000 that would be subject potentially to long-term capital gains taxes.
However, just to note that if you follow the tax rules properly (and you can look them up and read them in IRS publications), you can take a $500,000 married filing jointly long term capital gains exclusion on residential property. For single people, that would be a quarter-million-dollar exclusion.
This exclusion is very advantageous and useful in this particular situation. The married exclusion takes the $600,000 long-term capital gain, and reduces it by $500,000 down to $100,000. I am noting here and including this example, that they have $5,000 of qualified dividends, so the total amount of taxable income that is subject to long-term capital gains tax rates will be $105,000.
Now here’s a conceptual review from the first video that explains how the taxes are calculated in this case were this is an example for married taxpayers. We are using 2016 tax rates on this $105,000 of long term capital gains and this total ordinary taxable income of $35,000.
If you look at this arrow here, this illustrates what the LTCG tax rates are. First, let’s pay attention to this area from zero up to $75,300. This is the break point between the 0% long-term capital gains tax rate and the 15 percent long-term capital gains tax rate.
If you are so lucky as to have much higher income that you would hit this break point up here, your long-term capital gains tax rate above $466,950 would move up to twenty percent. But, in this case we are just keeping to a more simple example and showing what happens with the zero and the fifteen percent tax rates.
Like I said, if the couple in this example had no other ordinary income, then the first $75,300 of long term capital gains would be subject to a zero percent tax rate. However, the way the US federal tax system works is that ordinary income will act kind of like a plunger. Any ordinary income will push up other income subject to long term capital gains taxes into higher tax rate brackets, even though indeed these LTCG rates are relatively low compared to ordinary income tax rates.
So, in this example the $35,000 of ordinary income occupies some of this LTCG range between $0 and $75,300. The taxes on this $35,000 of ordinary income using 2016 tax rates would be $4,328 dollars. You just get that figure from the ordinary income tax rate tax tables.
Now to calculate the long-term capital gains you take the $75,300 LTCG tax break point here, and you subtract the $35,000. W@hat remains of this range is then $40,300. This $40,300 of long-term capital gains is taxed at a zero percent tax rate or has no taxes applicable. To calculate the remainder, you take the total amount of $105,000 and you subtract the amount that was taxed at zero percent. So that is $105,000 minus $40,300, which equals $64,700 that will be taxed at a 15 percent long-term capital gains tax rate, using 2016 tax rates. The LTCG taxes would be $9,705 in federal long term capital gains taxes. If you take this $9,705 and divide it by $105,000 the effective overall average long-term capital gains tax rate is roughly 9.2%.
Now, I am going to move on to the federal IRS tax forms. The first one we will look at is the Form 1040. You will note here I am using 2016 tax rates, because I have them available. However, what we are looking at here is a 2015 tax form 1040. Normally, tax forms on the irs.gov website are always a year behind, because in early 2016 we were still dealing with filing for 2015 taxes. (Note also to make sure the site is irs.gov, which is the official site, and not some other .com, .net, etc. site, which are not official US government tax websites.)
With this Form 1040,I do not have all the other details that would that you would fill. I am just filling in the relevant lines for this example. You will see here the $55,600 of wages and salaries that this is the ordinary income. Next, you see the dividends and they are all qualified dividends subject to long-term capital gains tax rates. Next, here is the capital gain on the home sale that nets out as $100,000. This flows into the Form 1040 from other tax forms. I am not going to look at the details from these supporting tax forms.
When you add these amounts on this first page of the Form 1040, the result is $160,600 that carries to the second page of Form 1040 as your adjusted gross income. Next, this is where the itemized deduction or the standard deduction gets inserted and then subtracted from the adjusted gross income. This $12,600 amount here is this case when you are using the standard deduction for 2016 for a married couple. This $12,600 standard deduction for 2016 will reduce taxable income to $148,000. After that one takes out the exemptions which is another $8,000 for two people. The resulting amount is the net taxable income of $140,000.
The combined ordinary income tax an long-term capital gains tax is $14,033. The question is how did one get to this total tax amount?
What we need to do is to go to the instructions for Form 1040 and look for the worksheet for line 44. Now, obviously, if you are using a CPA or using automated taxation software, this is already being calculated for you. What we are looking at here is what a person who is doing their taxes by hand would have to do. Yet this also helps you to understand how the taxes are actually calculated.
So that the top of the Line 44 Worksheet, here is the $140,000 of taxable income that will transfer in. On this worksheet, also note that these blue annotations here do not come with the form. These are annotations that I added to try to make this a little bit more clear.
We have $140,000 of total taxable ordinary income and capital gains. The long-term capital gains composed of %5,000 worth of qualified dividends plus $100,000 for the capital gains on the house. Then, any time you see an annotation that says “calculation” it is just a calculation the you happens when you read the instructions for individual lines of the worksheet.
I have already explained conceptually how this works, but if you pause the video and begin to study this form, you will see how it actually works. This can be rather confusing, unless you give yourself some time.
What happens here is that you add these two lines together and it is $105,000. This derives the total amount that would be taxed as a long-term capital gain and then that subtracted from $140,000 to get $35,000. I will not go over all the individual line details, but you can begin to see some of the numbers that are the same as the graphical example one the slide that I explained previously.
This is the $64,700 remaining that is subject to fifteen percent tax and the amount up here is the amount that was excluded so this is the area that calculates the twenty percent long-term capital gains. In this situation, since we haven’t exceeded that particular higher break point then obviously the tax on that is $0.
So this line is the $14,033 total tax amount that we saw transferred into Form 1040. That is composed of adding this 15% LTCG tax number plus the $0 for the 20% LTCG bracket plus the $4,328 of ordinary income taxes on the $35,000. This line near the bottom with $26,543 shows the taxes that would have been due, if the entire $140,000 would have been taxed at ordinary graduated federal income tax rates for 2016. The difference between this and this is a total of $12,510 and this measures the tax savings on having $105,000 be taxed 0% and 15% LTCG tax rates rather than the entire amount being taxed as ordinary income.
So in summary, that is the way long term capital gains taxes work. It is not simple and not easy to understand. However, once you understand this it may actually encourage you to go find a decent tax software application to do your own taxes or to find a competent CPA who also uses one.
Thank you very much for listening.
