Part F. Capital Gains and Losses

• Pages: 417-489
• Author: Marvin A. Chirelstein,Lawrence Zelenak

417

Part F

CAPITAL GAINS AND LOSSES

16. Introduction

16.01 Some History; Repeal and Reinstatement

At the moment, the top marginal tax rate on most income

(“ordinary” income, in the jargon of the Code) is 37%, but the top rate

on most long-term capital gains is only 20%. A long-term capital gain

is gain on the sale or exchange of a “capital asset” which the taxpayer

has held for more than one year. Capital assets are defined by § 1221

in a manner that covers most assets held for investment; shares of

stock and land held for appreciation are classic examples. Apart from

a few years following the enactment of the Tax Reform Act of 1986,

our law has consistently awarded a “preference” to long-term capital

gains, either by exempting a portion of such gains from tax or by

taxing such gains at a bargain rate. In 1986, Congre ss reduced the

top marginal rate for individual taxpayers to 28 %, and simply

repealed the preferential treatment of capital gains. The effect of the

latter step was to require capital gains to be included in gross income

in full and to tax such gains at the same top rate —28%—as income

from ordinary sources. The element of “preference” thus disappeared

entirely. Congressional tax -writers were of course aware that the

preponderance of capital gains goes to high-bracket taxpayers; with

the top individual r ate cut nearly in half, it was fel t that the “need”

(as the Senate Committee put it) to maintain a reduced rate for

capital gains no longer existed and, hence, that ordinary income and

capital gains could be taxed alike.

Despite repeal of the capital gain preference, Congress kept in

place all of the complex definitional and computational

paraphernalia described in the Sections following , so that taxpayers

were still required to di stinguish capital gains and losses from

ordinary gains and losses. A major reason for retaining (instead of

wiping out) the whole burdensome statutory scheme was that

Congress thought it important to protect the revenues by restricting

the deductibility of capital losses. As noted much earlier (5.01, 5.05),

the realization—and hence the timing—of investment gains and

losses is largely voluntary: a taxpayer can sell his property this year,

next year, or never. Because only realized gains are subject to tax, a

permission to offset investment losses against ordinary income would

prompt taxpayers to realize their losses immediately while

postponing the re alization of their gains, with po ssibly damaging

418

CAPITAL GAINS AND LOSSES

PT. F

consequences to the fisc. Thus, a taxpayer owning stock X which has

appreciated in value by $100,000 and stock Y which has declined in

value by $100,000 (and whose net worth is therefore unchanged)

might well elect to sell Y but retain X and use his Y loss to eliminate

tax on his salary or business income. To prevent this outcome, the

1986 Act continued the prior law restriction contained in Code

§ 1211. In effect, realized capital losses can be offset only against

realized capital gains (plus $3,000 of ordinary income). The Y loss

thus produces a significant tax benefit for the taxpayer only if and

when he realizes the X gain (or of course any other capital gain).

The equalization of ordinary income and long-term capital gain

rates under the 1986 Act , and the elimination of the capital gain

preference, did not last very long. The current top rate on most long-

term capital gains (20%) i s slightly more than half the top marginal

rate on ordinary income (37%). Under Code § 1(h) the tax rate on net

capital gain (i.e., the excess of net long-term gain over net short-term

loss) depends on the amount of the taxpayer’s taxable income. To the

extent a taxpayer’s net capital gain, when combined with the

taxpayer’s other taxable income, would not re sult in taxable income

of more than $98,900 (joint return), $66,200 (head of household), or

$49,450 (single taxpayer), the gain is not taxed. To the extent a

taxpayers’ net capital gain would result in taxable income higher

than the relevant above amount, but lower than $613,700 (joint

return), $579,600 (head of household), or $545,500 (single), the gain

is taxed at 15%. Any remaining gain is t axed at 20%.

1

Suppose, for

example, an unmarried taxpayer has $800,000 of taxable income,

consisting of $600,000 of ordinary income and $200,000 of net capital

gain. She would subtract her net capital gain and compute the tax—

under her § 1 tax rate schedule, featuring a top rate of 37%—on her

remaining income of $600,000. Because the $200,000 of net capital

gain, when metaphorically stacked on top of the taxpayer’s $600,000

of ordinary income , is entirely above the $545,500 threshold for the

20% rate, al l $200,000 of gain is taxed at 20%. The taxpayer’s total

tax is the sum of the tax on $600,00 0 at ordinary income rates and

the 20% tax on $200,000. Most corporate dividends are also taxed at

the rates applicable to net capital gain. Technically, however,

dividends continue to be classified as ordinary income, with the

result that they cannot be offset by capital losses.

The capital gains preference differs f rom the norm for a few

special asset categories. Under § 1(h), gains from the sale of so-called

collectibles—jewelry, antiques, fine art—continue to be taxed at the

old 28% rate (or the taxpayer’s marginal tax rate on ordinary income,

1

All dollar thresholds in the text are for 2026; the thresholds will be adjusted

for inflation in later years.

SEC. 16

INTRODUCTION

419

whichever is lower). Section 1202 provides that “qualified small

business stock” enjoys a gain exclusion of 50%, 75% or 100%,

depending on how long the taxpayer owned the stock, with the 100%

exclusion applying if the taxpayer held the stock for at least five

years. Finally, gains on sales of depreciable real estate—§ 1231

property—are taxed under a special regime, which is described at

18.02, below.

Whether the capital gain preference is wise or unwise as a

matter of national e conomic policy has been debated by tax

specialists for decades, and perhaps the safest thing to say is that the

question is debatable. What cannot be denied, however, is that the

decision to treat capital gains in a special way adds substantially to

the complexity of the federal income tax. The e ffect of this is felt by

students, who are obliged to devote much more study time to the

material that follows than might otherwise be required, by practicing

lawyers, who must tirelessly eng age in “planning” their clients’

transactions so as to maximize capital gain and minimize ordinary

income, and by the Internal Revenue Service itself, which has the

task of policing the relevant statutory distinctions. According to a

Service publication, that particular task—determining when capital

gain treatment is appropriate and when it is not—has absorbed more

administrative time and effort on the part of government personnel

than any other single feature of the Internal Revenue Code.

Wise or otherwise, the capital gain preference comes at a high

cost to the system.

16.02 Legislative Purpose

With only one brief intermission, preferential treatment for

capital gains has been a major feature of the federal income tax since

1922. Generally speaking, it applies to long -term gains from sales of

investment property and permits those gains to be taxed at

substantially lower rates than the rates that apply to “ordinary”

income.

How can this longstanding tax concession be explained? What

justifies the special treatment of investment gains? Curiously in view

of its signific ance to the re venues, the capital gain prefere nce has

never received a systematic exposition in any official source.

Congressional committee reports, debates, etc., contain little on the

subject of underlying policy, apart from occasional references to

“fairness,” “incentives” and the like. Some of the po licy justifications

offered by commentators for the capital gains p reference have

obvious weaknesses. For example, it is sometime s argued that a

capital gains ra te preference is needed to prevent “bunching”—that

is, taxation of income at an inappropriately high marginal tax rate