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 capital 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 capital gains are those that are held one year or less.  Short-term capital 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%.

ACTION ITEM:  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®