For the love of god, please explain IRS 1(h) to me Forum
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victortsoi
- Posts: 450
- Joined: Wed Mar 10, 2010 7:51 pm
For the love of god, please explain IRS 1(h) to me
I can't understand the capital gains tax section IRS 1(h). Please, can some tax genius please explain to this lost traveler how to determine capital gains based on section 1h? Say for example someone has 140K of ordinary income and 40K of long term capital gains. what would the analysis based on 1h be?
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TheNextAmendment
- Posts: 309
- Joined: Tue Mar 12, 2013 10:44 pm
Re: For the love of god, please explain IRS 1(h) to me
Good timing. Hope this helps:
I. BASIC THINGS TO UNDERSTAND
- Capital gains are taxed at a preferential rate, but Capital losses can only offset ordinary income at a maximum amount of $3k/year.
- Therefore, a taxpayer wants to characterize every gain as a Capital Gain, and every loss as an Ordinary Loss.
- What "thing" qualifies for capital gain or loss treatment? A Capital Asset. Think of a capital asset as something that was acquired for investment purposes. However, keep in mind that an asset may be Ordinary to one person, but Capital to another. For example, A buys a house to sell for profit. B sells a house (the same exact house) for profit. A is a realtor a buys 20+ houses a year as her main means of earning income, while B is just some teacher that buys this house thinking it was a good deal. The house is an Ordinary Asset for A because it is part of her business. However, the house is a Capital Asset for B because the teacher merely bought the house for investment purposes.
- This next part is key-> No Personal Expenditures can be capital assets. An asset must first be a business expenditure (aka pass the ordinary and necessary test) before it goes through the capital asset test.
II. WHAT THE HELL IS 1(H)
IIA. Long-Term vs. Short-Term Treatment
- 1(h) does two main things: it explains long-term vs. short-term capital treatment AND lists tax rates for specific capital assets.
You MUST distinguish treatment into 4 pigeon-holes: long-term capital gain, long-term capital loss, short-term capital gain, short-term capital loss. What makes an asset long-term? If the taxpayer has held it for at least 1 year. Therefore, consider the following:
1) A buys a house for 10k and the market goes up and A sells it for 20k after 1.5 years- LONG-TERM CAPITAL GAIN OF 10K
2) A buys a house for 10k and the market goes up and A sells it for 20k within 6 months- SHORT-TERM CAPITAL GAIN OF 10K
3) A buys a house for 10k and the market goes to shit and A sells it for 5k after 1.5 years- LONG-TERM CAPITAL LOSS OF 5K.
4) A buys a house for 10k and the market goes to shit and A freaks out and sells it for 5k within 6 months- SHORT-TERM CAPITAL LOSS OF 5K.
Why the hell do we care if it is long-term or short-term? Well, Congress wanted a preferential cap gains rate to encourage people to invest in shit and hold on to it for a while. Therefore, under 1(h): long-term capital gain gets preferential treatment, but short-term capital gain gets taxed at ordinary rates. Losses are treated the same (for tax arbitrage reasons, but don't worry about this): so in both cases of long-term capital loss and short-term capital loss, a taxpayer (A) can deduct the loss against ordinary income but only at 3k per year and every year after that until its gone.
IIB. Specific Rates In 1(h)
-To make life even more difficult, the IRS decided it was a good idea to have different capital gains RATES set out in 1(h). These are the tax rates that apply to long-term capital gains all depending on the capital asset. These rates only apply if the taxpayer has a higher marginal rate (this is why capital gains treatment typically only helps the rich).
-28% capital gain tax rate applies to collectibles (Lincoln's hat, a magic flute, a painting, etc.).
-25% capital gain tax rate applies to real property (with limitations beyond 1(h))
-the catch-all other capital assets group. 1(h) provides that if it isnt a 28% asset or a 25% asset, it falls in this group in which case the tax gain rate is: 20% if A's marginal tax rate is 39.6%, 15% if taxpayer's marginal tax rate is 25% but less than 39.6%, etc. (Congress did this to make sure poor people got a benefit here too).
III. STEPS
STEP 1-> Does this asset pass ordinary and necessary test?
STEP 2-> Does this asset qualify as a capital asset?
STEP 3-> Did Taxpayer make a gain or a loss on this asset? (this is only if taxpayer has 1 capital gain/loss in the year. If he has multiple, you net the losses and gains.)
STEP 4-> Was this gain or loss long-term or short-term? (Keep in mind that you only have to go to step 5 if the asset has long-term capital gain)
STEP 5-> Is this a 28% asset, a 25% asset, or an Other Asset Group asset?
STEP 6-> What bracket is Taxpayer in and what official rate applies to the capital asset?
STEP 7-> Work through Taxpayer's tax structure to figure out how the tax applies. (see below)
IV. FINAL EXAMPLES
Examples: (for the following examples assume the following tax schedule: income up to 10k (0%), income up to 50k (10%), income up to 150k (25%), income over 300k (50%- oh whatup FDR). Taxpayer in examples is in the top bracket. I am using my own tax schedule to simplify my work, so for purposes of the other capital assets section in 1(h) assume that the taxpayer's rate is 39.6%. I will skip steps 1-4 to focus on 1(h). Additionally, we will assume that the Taxpayer has 1 capital gain/loss on the year to avoid the issue of netting the gains or losses.
Example 1) A has income of 140k and 40k of long-term capital gain and the asset here is a collectible (this is your example). A pays the following tax: 0% on first 10k, 10% on next 40k, 25% on next 90k. Ordinary income is now covered. Now on to capital gain treatment. Oh shit, well he still has 10k worth of room in the 25% bracket, so the first 10k of the 40k capital gain is taxed at 25% and the rest of it (30k) is taxed at 28% (because 28% is lower than the 50% rate).
Example 2) A has income of 140k and 40k of long-term capital gain and the asset here is stock that falls in the Other Capital Assets Section. Because A is in the top bracket (which in 1(h) is 39.6% while in my example is 50%) A's capital gain tax rate on that stock is 20%. A pays the following tax: 0% on first 10k, 10% on next 40k, 25% on next 90k. Ordinary income is now covered. There is still 10k "room" left in the 25% bracket, but 25% is MORE than 20%, therefore the entire 40k of capital gain is taxed at the preferential rate of 20%. (Keep in mind that if A had a different marginal tax rate then this entire analysis would change under the Other Assets Group).
Example 3) A has income of 140k and 40k of short-term gain. We dont care what the asset is (28%, 25%, or other group) because its short-term so treat it like ordinary income.
Example 4) A has income of 140k and 40k of short-term or long-term loss. We dont care what the asset is (28%, 25%, or other group) because all losses are treated the same- they only offset ordinary income. Therefore, how much of that 40k can A deduct from her ordinary income? ONLY 3k per year. But she can deduct 3k every single year until she deducts the entire 40k. Well, that sucks for taxpayer A. IF the loss was ordinary loss and not capital loss A could deduct the ENTIRE 40k instead of just 3k. Why does A care? Time value of money. Because this asset is a capital asset, A now has to sit on a 37k loss and deduct a measly 3k per year.
This is the general gist of 1(h). Godspeed.
I. BASIC THINGS TO UNDERSTAND
- Capital gains are taxed at a preferential rate, but Capital losses can only offset ordinary income at a maximum amount of $3k/year.
- Therefore, a taxpayer wants to characterize every gain as a Capital Gain, and every loss as an Ordinary Loss.
- What "thing" qualifies for capital gain or loss treatment? A Capital Asset. Think of a capital asset as something that was acquired for investment purposes. However, keep in mind that an asset may be Ordinary to one person, but Capital to another. For example, A buys a house to sell for profit. B sells a house (the same exact house) for profit. A is a realtor a buys 20+ houses a year as her main means of earning income, while B is just some teacher that buys this house thinking it was a good deal. The house is an Ordinary Asset for A because it is part of her business. However, the house is a Capital Asset for B because the teacher merely bought the house for investment purposes.
- This next part is key-> No Personal Expenditures can be capital assets. An asset must first be a business expenditure (aka pass the ordinary and necessary test) before it goes through the capital asset test.
II. WHAT THE HELL IS 1(H)
IIA. Long-Term vs. Short-Term Treatment
- 1(h) does two main things: it explains long-term vs. short-term capital treatment AND lists tax rates for specific capital assets.
You MUST distinguish treatment into 4 pigeon-holes: long-term capital gain, long-term capital loss, short-term capital gain, short-term capital loss. What makes an asset long-term? If the taxpayer has held it for at least 1 year. Therefore, consider the following:
1) A buys a house for 10k and the market goes up and A sells it for 20k after 1.5 years- LONG-TERM CAPITAL GAIN OF 10K
2) A buys a house for 10k and the market goes up and A sells it for 20k within 6 months- SHORT-TERM CAPITAL GAIN OF 10K
3) A buys a house for 10k and the market goes to shit and A sells it for 5k after 1.5 years- LONG-TERM CAPITAL LOSS OF 5K.
4) A buys a house for 10k and the market goes to shit and A freaks out and sells it for 5k within 6 months- SHORT-TERM CAPITAL LOSS OF 5K.
Why the hell do we care if it is long-term or short-term? Well, Congress wanted a preferential cap gains rate to encourage people to invest in shit and hold on to it for a while. Therefore, under 1(h): long-term capital gain gets preferential treatment, but short-term capital gain gets taxed at ordinary rates. Losses are treated the same (for tax arbitrage reasons, but don't worry about this): so in both cases of long-term capital loss and short-term capital loss, a taxpayer (A) can deduct the loss against ordinary income but only at 3k per year and every year after that until its gone.
IIB. Specific Rates In 1(h)
-To make life even more difficult, the IRS decided it was a good idea to have different capital gains RATES set out in 1(h). These are the tax rates that apply to long-term capital gains all depending on the capital asset. These rates only apply if the taxpayer has a higher marginal rate (this is why capital gains treatment typically only helps the rich).
-28% capital gain tax rate applies to collectibles (Lincoln's hat, a magic flute, a painting, etc.).
-25% capital gain tax rate applies to real property (with limitations beyond 1(h))
-the catch-all other capital assets group. 1(h) provides that if it isnt a 28% asset or a 25% asset, it falls in this group in which case the tax gain rate is: 20% if A's marginal tax rate is 39.6%, 15% if taxpayer's marginal tax rate is 25% but less than 39.6%, etc. (Congress did this to make sure poor people got a benefit here too).
III. STEPS
STEP 1-> Does this asset pass ordinary and necessary test?
STEP 2-> Does this asset qualify as a capital asset?
STEP 3-> Did Taxpayer make a gain or a loss on this asset? (this is only if taxpayer has 1 capital gain/loss in the year. If he has multiple, you net the losses and gains.)
STEP 4-> Was this gain or loss long-term or short-term? (Keep in mind that you only have to go to step 5 if the asset has long-term capital gain)
STEP 5-> Is this a 28% asset, a 25% asset, or an Other Asset Group asset?
STEP 6-> What bracket is Taxpayer in and what official rate applies to the capital asset?
STEP 7-> Work through Taxpayer's tax structure to figure out how the tax applies. (see below)
IV. FINAL EXAMPLES
Examples: (for the following examples assume the following tax schedule: income up to 10k (0%), income up to 50k (10%), income up to 150k (25%), income over 300k (50%- oh whatup FDR). Taxpayer in examples is in the top bracket. I am using my own tax schedule to simplify my work, so for purposes of the other capital assets section in 1(h) assume that the taxpayer's rate is 39.6%. I will skip steps 1-4 to focus on 1(h). Additionally, we will assume that the Taxpayer has 1 capital gain/loss on the year to avoid the issue of netting the gains or losses.
Example 1) A has income of 140k and 40k of long-term capital gain and the asset here is a collectible (this is your example). A pays the following tax: 0% on first 10k, 10% on next 40k, 25% on next 90k. Ordinary income is now covered. Now on to capital gain treatment. Oh shit, well he still has 10k worth of room in the 25% bracket, so the first 10k of the 40k capital gain is taxed at 25% and the rest of it (30k) is taxed at 28% (because 28% is lower than the 50% rate).
Example 2) A has income of 140k and 40k of long-term capital gain and the asset here is stock that falls in the Other Capital Assets Section. Because A is in the top bracket (which in 1(h) is 39.6% while in my example is 50%) A's capital gain tax rate on that stock is 20%. A pays the following tax: 0% on first 10k, 10% on next 40k, 25% on next 90k. Ordinary income is now covered. There is still 10k "room" left in the 25% bracket, but 25% is MORE than 20%, therefore the entire 40k of capital gain is taxed at the preferential rate of 20%. (Keep in mind that if A had a different marginal tax rate then this entire analysis would change under the Other Assets Group).
Example 3) A has income of 140k and 40k of short-term gain. We dont care what the asset is (28%, 25%, or other group) because its short-term so treat it like ordinary income.
Example 4) A has income of 140k and 40k of short-term or long-term loss. We dont care what the asset is (28%, 25%, or other group) because all losses are treated the same- they only offset ordinary income. Therefore, how much of that 40k can A deduct from her ordinary income? ONLY 3k per year. But she can deduct 3k every single year until she deducts the entire 40k. Well, that sucks for taxpayer A. IF the loss was ordinary loss and not capital loss A could deduct the ENTIRE 40k instead of just 3k. Why does A care? Time value of money. Because this asset is a capital asset, A now has to sit on a 37k loss and deduct a measly 3k per year.
This is the general gist of 1(h). Godspeed.
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victortsoi
- Posts: 450
- Joined: Wed Mar 10, 2010 7:51 pm
Re: For the love of god, please explain IRS 1(h) to me
Thank you so much for this....just to make sure I get it, in example 2, using the IRS Code tables, and assuming he is unmarried, and his total income according to my problem is 180K, then in 2014 he would be taxed 18,193.75 plus 28% of the excess over 89350.
So 28% of 49350, and then you have to apply the LTCG rates to the 40K....am I approaching this correctly?
I am getting hung up mostly on 1(H) (1) subsections. I'm really sorry if my question isnt clear, this is really unclear to me
So 28% of 49350, and then you have to apply the LTCG rates to the 40K....am I approaching this correctly?
I am getting hung up mostly on 1(H) (1) subsections. I'm really sorry if my question isnt clear, this is really unclear to me
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TheNextAmendment
- Posts: 309
- Joined: Tue Mar 12, 2013 10:44 pm
Re: For the love of god, please explain IRS 1(h) to me
The following tax schedule is taken directly from IRS 1 for unmarried individuals:
If taxable income is:---- The tax is:
Not over $22,100---- 15% of taxable income.
Over $22,100 but not over $53,500---- $3,315, plus 28% of the excess over $22,100.
Over $53,500 but not over $115,000---- $12,107, plus 31% of the excess over $53,500.
Over $115,000 but not over $250,000---- $31,172, plus 36% of the excess over $115,000.
Over $250,000---- $79,772, plus 39.6% of the excess over $250,000.
Taxable Income for A is 180k, but it helps to keep the two concepts separate: 140k of Ordinary Income and 40k of long-term Capital Gains.
I'll break it down into steps to make it easier:
STEP 1-> Figure out the tax due on his Ordinary Income. A has 140k of Ordinary Income. Therefore, he will be taxed $31,172 + 36% of the excess over $115,000. Therefore, A pays $31,172 + $9,000 (.36 x 25,000) = $40, 172.
STEP 2-> Figure out the tax due on his Capital Gains. A has 40k of LTCG. In Example 2 the asset was in the Other Capital Assets Section (referred to as the adjusted net capital gain). Under 1(h) the capital gain rate on this type of gain is: (1) 20% if the taxpayer's marginal ordinary income rate is 39.6%, (2) 15% if taxpayer's marginal ordinary income rate is 25%+ but less than 39.6%, or (3) 0% if the taxpayer's marginal ordinary income rate is less than 25%. A has a marginal ordinary income rate of 36% because his taxable income is over $115,000 but not over $250,000. Therefore, A faces a maximum capital gains tax rate of 15%. It is called the maximum capital gain tax rate because it is the LESSER OF the capital gains tax rate set out in 1(h) or the taxpayer's marginal ordinary income rate. Here, A faces a marginal ordinary income rate of 36% which is higher than 15%, so his capital gains tax rate is 15%. Therefore, A pays .15 x 40,000 = $6,000 in capital gains tax.
STEP 3-> Add the Two. $40,172 + $6,000 = $46,172 of total tax liability.
If taxable income is:---- The tax is:
Not over $22,100---- 15% of taxable income.
Over $22,100 but not over $53,500---- $3,315, plus 28% of the excess over $22,100.
Over $53,500 but not over $115,000---- $12,107, plus 31% of the excess over $53,500.
Over $115,000 but not over $250,000---- $31,172, plus 36% of the excess over $115,000.
Over $250,000---- $79,772, plus 39.6% of the excess over $250,000.
Taxable Income for A is 180k, but it helps to keep the two concepts separate: 140k of Ordinary Income and 40k of long-term Capital Gains.
I'll break it down into steps to make it easier:
STEP 1-> Figure out the tax due on his Ordinary Income. A has 140k of Ordinary Income. Therefore, he will be taxed $31,172 + 36% of the excess over $115,000. Therefore, A pays $31,172 + $9,000 (.36 x 25,000) = $40, 172.
STEP 2-> Figure out the tax due on his Capital Gains. A has 40k of LTCG. In Example 2 the asset was in the Other Capital Assets Section (referred to as the adjusted net capital gain). Under 1(h) the capital gain rate on this type of gain is: (1) 20% if the taxpayer's marginal ordinary income rate is 39.6%, (2) 15% if taxpayer's marginal ordinary income rate is 25%+ but less than 39.6%, or (3) 0% if the taxpayer's marginal ordinary income rate is less than 25%. A has a marginal ordinary income rate of 36% because his taxable income is over $115,000 but not over $250,000. Therefore, A faces a maximum capital gains tax rate of 15%. It is called the maximum capital gain tax rate because it is the LESSER OF the capital gains tax rate set out in 1(h) or the taxpayer's marginal ordinary income rate. Here, A faces a marginal ordinary income rate of 36% which is higher than 15%, so his capital gains tax rate is 15%. Therefore, A pays .15 x 40,000 = $6,000 in capital gains tax.
STEP 3-> Add the Two. $40,172 + $6,000 = $46,172 of total tax liability.
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TheNextAmendment
- Posts: 309
- Joined: Tue Mar 12, 2013 10:44 pm
Re: For the love of god, please explain IRS 1(h) to me
In case you already read my posts and wont see my edit victortsoi please see the following:
*EDIT- A capital asset does NOT need to pass the ordinary and necessary test (i.e. be a business expenditure) to qualify for capital gains treatment. Therefore, even if A just likes to invest in stocks as a hobby but he works at Dairy Queen, the gain CAN qualify for capital gain. The IRC (consciously) uses confusing like-terms to increase the complexity of tax law. Therefore, always remember that there is a difference between capitalization and capital asset and capital gain. I will elaborate:
A gain/loss only qualifies for capital gain (or loss) treatment if it is a capital asset. A capital asset does not have to have a business purpose, but can also have a personal purpose.
An expenditure can either be deducted fully in the year of purchase (expensed) or required to be capitalized and then depreciated over time. An expenditure can ONLY be expensed or capitalized if it is a business expenditure (ordinary and necessary test) because the IRC doesn't allow for any kind of personal deductions (other than ones provided for in the IRC- charitable donations, local taxes, etc., etc.).
Separate the three concepts in your head NOW and I guarantee you will be ahead of the curve come finals time. Capital Asset vs. Capital Gain vs. Expenditure Subject to Capitalization. It's confusing shit...I even mix them up sometimes, as was demonstrated yesterday...
(*side note- another example of the IRC using like-terms is its use of personal expenditure and personal property. A personal expenditure cannot get deducted because it is consumption. When the IRC talks of property as either real or personal property, they are not referring to the same thing. In this case, real property means ""things you *cannot pick up and move""" (remember from Property Law). Therefore, land and real estate (excluding a motor home) is not personal property, but real property. I'm sure you already knew the difference between real and personal property, but wanted to inform you that the difference between the two kinds of properties is upheld in the tax system.)
*EDIT- A capital asset does NOT need to pass the ordinary and necessary test (i.e. be a business expenditure) to qualify for capital gains treatment. Therefore, even if A just likes to invest in stocks as a hobby but he works at Dairy Queen, the gain CAN qualify for capital gain. The IRC (consciously) uses confusing like-terms to increase the complexity of tax law. Therefore, always remember that there is a difference between capitalization and capital asset and capital gain. I will elaborate:
A gain/loss only qualifies for capital gain (or loss) treatment if it is a capital asset. A capital asset does not have to have a business purpose, but can also have a personal purpose.
An expenditure can either be deducted fully in the year of purchase (expensed) or required to be capitalized and then depreciated over time. An expenditure can ONLY be expensed or capitalized if it is a business expenditure (ordinary and necessary test) because the IRC doesn't allow for any kind of personal deductions (other than ones provided for in the IRC- charitable donations, local taxes, etc., etc.).
Separate the three concepts in your head NOW and I guarantee you will be ahead of the curve come finals time. Capital Asset vs. Capital Gain vs. Expenditure Subject to Capitalization. It's confusing shit...I even mix them up sometimes, as was demonstrated yesterday...
(*side note- another example of the IRC using like-terms is its use of personal expenditure and personal property. A personal expenditure cannot get deducted because it is consumption. When the IRC talks of property as either real or personal property, they are not referring to the same thing. In this case, real property means ""things you *cannot pick up and move""" (remember from Property Law). Therefore, land and real estate (excluding a motor home) is not personal property, but real property. I'm sure you already knew the difference between real and personal property, but wanted to inform you that the difference between the two kinds of properties is upheld in the tax system.)
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bnghle234
- Posts: 105
- Joined: Tue Apr 10, 2012 7:21 pm
Re: For the love of god, please explain IRS 1(h) to me
I'm confused as to how you come to this "10k worth of room in the 25% bracket" treatment. Where in the code does it say that you fill up your bracket and anything over gets the capital gain treatment? I thought anything characterized as LTCG gets a separate marginal rate (with your example and collectibles, it would be 28%).
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TheNextAmendment
- Posts: 309
- Joined: Tue Mar 12, 2013 10:44 pm
Re: For the love of god, please explain IRS 1(h) to me
There are 3 different rates for different kinds of assets.bnghle234 wrote:I'm confused as to how you come to this "10k worth of room in the 25% bracket" treatment. Where in the code does it say that you fill up your bracket and anything over gets the capital gain treatment? I thought anything characterized as LTCG gets a separate marginal rate (with your example and collectibles, it would be 28%).
28%-collectibles
25%-unrecaptured gain (1231 property)
The last one is for all other capital assets under 1221. However, for these kinds of assets you have to look to the rates in 1(h). You are correct that if there is capital gain it is subject to a different rate, but ONLY if that rate is lower than the TP's marginal rate for Ordinary income. Therefore, if the asset you have is a 1221 and subject to the 1(h) rates, the rate you apply to that gain is the lesser of: (1) TP's ordinary marginal rate or (2) the capital gains rate in 1(h).
