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Is the Schedule D Tax Computation Worksheet Flawed?

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    Is the Schedule D Tax Computation Worksheet Flawed?

    In a recent post titled "Do you have a working understanding of basic income tax rates?" the question was asked how much a taxpayer's federal tax would increase if he took a $10,000 distribution from his IRA that year. The answer was $3,000 ... 30% of the $10,000. You may read kathyc2's reply for a very good and concise explanation of this surprising result. (Well, surprising if you weren't already aware of the phenomenon.)

    This post poses a similar kind of question but based on a different category of additional income. I invite all interested readers to do the following: (1) Set up a "test/pretend" taxpayer using your tax prep program, using the same facts as listed in the other post referred to above. You should get a tax balance due of $8. (2) Go to your 1099-DIV screen and enter $1,000 of capital gains dividends, 100% of which is also Unrecaptured §1250 Gain. These $1,000 amounts would be reported on form 1099-DIV in boxes 2a and 2b. Note that the $1,000 in box 2b is not an additional $1,000 of income, but rather it is the same $1,000 that's reported in box 2a, but in a special category.

    The taxpayer's income has, thus, been increased by $1,000, and the entire $1,000 consists entirely of Unrecaptured §1250 Gain. How much should his federal tax have increased? IMO the tax on that additional $1,000 should be $150, but my tax prep software tells me the increase is $300, and I assume your tax prep program will produce the same result. I have followed the tax calculation on a line-by-line journey through the Schedule D Tax Computation Worksheet, and all the calculations are consistent with the in-line instructions on that worksheet. Nevertheless, I believe the result is wrong.

    We all know that Net Unrecaptured §1250 Gain is subject to special rules and tax rates. Nevertheless, it is still capital gain income. Is is not ordinary income. It's a tricky calculation, but however it's done, the tax on that income should never be greater than 25% even if the taxpayer is in one of the higher tax brackets. The reason for treating it separately is to keep that category of income from being taxed at 0% when the taxpayer's overall taxable income is below the start of the 25% tax rate bracket. This increases the probability that it will instead be taxed at 15%, or perhaps in some cases at just 10% ... the lowest bracket. And for taxpayers whose income, not counting his capital gains and qualified dividends, is already in the 25% bracket, or one of the higher ones, the Unrecaptured §1250 Gain will then be taxed at 25% instead of the lower 15% rate on LTCGs. This is covered in Code §1(h)(1)(E). Yet in the example here, that additional $1,000 results is $300 of additional tax, or 30%. Why? And who besides me thinks this is wrong?

    I believe the Schedule D Tax Computation Worksheet is flawed. It's a rather daunting exercise to follow it from top to bottom, and even when you do, it's difficult to say, with certainty, where the logic error is. Having tackled that beast, however, I believe the error is in line 25 of that worksheet, but it may really be due to a more fundamental design flaw based on an insufficient set of taxable income levels, broken down between ordinary and capital gain, combined with the various tax rates applicable to each. Using the facts in the present example, what that worksheet does is tax the $1,000 of Unrecaptured §1250 Gain twice ... first by including it in the income subject to the tax rates on ordinary income, and then again by including it in the total of LTCG income subject to the 0%/15% tax rates on that income. What the worksheet should do is transfer the $1,000 from the LTCG total, taxing it at ordinary income tax rates (but not more than 25%), and then figuring the tax on the remaining LTCG income, excluding that $1,000. When the tax law clearly says that the tax on Unrecaptured §1250 Gain shall be no greater than 25%, yet in this simple example we can see that it results in higher tax by 30%, it's pretty clear something is wrong.
    Roland Slugg
    "I do what I can."

    #2
    Schedule D Computation

    Excellent discussion and analogy.
    Instead of attempting to educate us - who are supposed to understand it - and appreciate your discussion- I believe you should save
    this for your U. S. Senators and Congressman who actually pass the tax laws we're obligated to abide by.
    Uncle Sam, CPA, EA. ARA, NTPI Fellow

    Comment


      #3
      There are Two Such Worksheets

      At least there are two provided by Drake. One of them is for capital gains/qualified dividends without the complications of Section 1250 "recapture." But if such Unrecaptured Section 1250 gain exists, a separate worksheet is provided.

      One of these is called "Schedule D Tax Worksheet". The instructions: "Complete this worksheet only if line 18 or line 19 of Schedule D is more than zero. Otherwise, complete the Qualified Dividends and Capital Gain Tax Worksheet in the instructions for Form 1040, Line 44...to figure your tax. Exception: Don't use the Qualified Dividends and Capital Gain Tax Worksheet or this worksheet to figure your tax if: *Line 15 or line 16 of Schedule D is zero or less and you have no qualified dividends on Form 1040, line 9b, or **Form 1040, line 43 is zero or less. Instead see the instructions for Form 1040, line 44." The Drake worksheet has 30 lines.

      To save you looking at a Sch D, Line 18 is for Unrecaptured Section 1250 gains (with a 25% ceiling) and Line 19 is for Collectibles (with a 28% ceiling).

      If there are neither of the above, there is a separate worksheet called "Qualified Dividends and Capital Gain Tax Worksheet" This is for taxpayers with capital gains/dividends, but have no collectibles or Unrecaptured Section 1250 gains. Believe it or not, for the first time in my life I had a "Collectibles" capital gain in 2016 on my own return. No idea what caused the income, but it came to me from some mutual fund.

      Going back to Mr Slugg's original post, Drake seems to have all his bases covered whether the IRS does or not.
      Last edited by Snaggletooth; 05-07-2017, 07:48 PM.

      Comment


        #4
        Stop trying to apply one kind of tax rate to another kind of income, and you'll do better.

        "Go to your 1099-DIV screen and enter $1,000 of capital gains dividends"

        Capital gain distributions, not dividends.

        " The answer was $3,000 ... 30% of the $10,000."

        No, it was 15% of the $10,000 IRA distribution, and and increase of 15% on some other income already in the return. That's not the same as 30% on $10,000.


        "The reason for treating it separately is to keep that category of income from being taxed at 0% when the taxpayer's overall taxable income is below the start of the 25% tax rate bracket. "

        I don't think so, as the Sec 1250 rate was in place long before the zero percent cap gains rate became available.


        "We all know that Net Unrecaptured §1250 Gain is subject to special rules and tax rates. Nevertheless, it is still capital gain income. Is is not ordinary income. It's a tricky calculation, but however it's done, the tax on that income should never be greater than 25% even if the taxpayer is in one of the higher tax brackets."

        You need to re-visit the code. Your cite was to §1(h)(1)(E), but that refers back to paragraph (A). And in paragraph A, we refer to something called "adjusted net capital gain", here is the definition, from the same code section:

        "(3) Adjusted net capital gain
        For purposes of this subsection, the term "adjusted net capital gain" means the sum of-
        (A) net capital gain (determined without regard to paragraph (11)) reduced (but not below zero) by the sum of-
        (i) unrecaptured section 1250 gain, and
        (ii) 28-percent rate gain, plus
        (B) qualified dividend income (as defined in paragraph (11))."


        In your scenario, the amount of L/T cap gains that is unrecaptured Sec 1250 gain actually is taxed as ordinary gain, since the amount of adjusted net capital gain does not change whether you have unrecap Sec 1250 gain or not.

        In other words, ordinary income increases by $1,000 taxed at 15%, and some other cap gains income, previously taxed at zero, is now taxed at 15% (just like in your original example). But the total amount of income taxed as capital gain income does not change. If it wasn't Unrecap Sec 1250 gain, just regular L/T cap gains distribution, you would get the result you expect.

        "yet in this simple example we can see that it results in higher tax by 30%, it's pretty clear something is wrong. "

        Again, the only thing that is wrong is assuming there is a 30% tax on the $1,000 of increased income.
        "You said it, they'll never know the difference. Come on, we'll paint our way out!" - Moe Howard

        Comment


          #5
          [comment: yes, this forum is very poor at allowing edits or quotes of previous posts, even after restarting my browser I still can't properly edit my post, and the quote function doesn't work either. Paging site admin!]

          "In your scenario, the amount of L/T cap gains that is unrecaptured Sec 1250 gain actually is taxed as ordinary gain, since the amount of adjusted net capital gain does not change whether you have unrecap Sec 1250 gain or not."

          What I meant to say was, the amount of adjusted net capital gain does not change when all you add is unrecap Sec 1250 gain. It basically doesn't count in the early steps of the calculation, only if the overall tax rate is going to get into the higher brackets.
          "You said it, they'll never know the difference. Come on, we'll paint our way out!" - Moe Howard

          Comment


            #6
            Data entry from Form 1099-DIV

            I'm not quite sure I follow your logic and/or your tax software.

            Generally numbers for a Form 1099-DIV are entered exactly as shown on the document itself. Boxes 1a and 1b are somewhat related, in that 1b can be just about anything from zero to the amount shown in 1a.

            Box 2a is for capital gain distributions, and box 2b is for any Unrecaptured Sect 1250 gain that is included in the box 2a amount. Your tax software should use the proper worksheet, dependent on entries for one/both of those two boxes, as well as for anything that might also have been entered in boxes 1a/1b.

            But you should never enter the same income in two places, as it appears you may be doing.

            In theory, you can have an amount shown in box 2a (and perhaps an entry in box 2b), with *NOTHING* shown in boxes 1a/1b .

            As for an "error" in the worksheet, I have serious doubts that any reputable tax software, especially a professional product, would have a calculation flaw in something as critical (and common) as a Schedule D tax calculation worksheet. (This assumes the tax information was entered accurately, of course.)

            FE

            Comment


              #7
              I believe you are saying that you added 1K to income in this situation? So now, the AGI is 55.5K rather than 54.5k?

              While 1250 may not technically be ordinary income, it is taxed at ordinary rates subject to a 25% cap.

              The add'l 1K is being taxed at 15%, and the higher AGI is pushing 1K of LTCG income from the 0% rate to the 15% rate.

              If instead of adding 1K income, you would have changed the original 8K of CG income, making 1K of it 1250, the result would be 150 add't tax or 15%. In this case the total income does not change, but 1K of it is being changed from LTCG rates to ordinary rates. You would also see the same result if you would have changed 1K of the original 8K from LT to ST capital gain.

              Comment


                #8
                To help close the loop on this, use the same scenario except change the $30K of rental income from the original to $100K.

                Then you will see that the difference between $1K of cap gains distributions alone, and $1K of cap gains distributions that is all due to Sec 1250 gain, is as follows:

                The income taxed at ordinary rates in both cases is $91,150, with the top bracket of 25%.

                The income taxed at cap gains rates in both cases is $24,000. However in the first case (no Sec 1250 gains) it is all taxed at 15%, while in the second case, $1K is taxed at 25% max cap gains rate.

                Therefore in this case, the extra tax due to Sec 1250 gain treatment is 10%, or $100.
                "You said it, they'll never know the difference. Come on, we'll paint our way out!" - Moe Howard

                Comment


                  #9
                  Originally posted by Roland Slugg
                  what that worksheet does is tax the $1,000 of Unrecaptured §1250 Gain twice ... first by including it in the income subject to the tax rates on ordinary income, and then again by including it in the total of LTCG income subject to the 0%/15% tax rates on that income. What the worksheet should do is transfer the $1,000 from the LTCG total, taxing it at ordinary income tax rates (but not more than 25%), and then figuring the tax on the remaining LTCG income, excluding that $1,000.
                  No, the worksheet does exactly what you say it should do. The $1K is taxed as ordinary income at 15%, and the amount of income taxed at LTCG rates DOES NOT CHANGE. Rather, some of the LTCG previously taxed at zero is now taxed at 15%. Do you understand basic income tax rates?
                  "You said it, they'll never know the difference. Come on, we'll paint our way out!" - Moe Howard

                  Comment

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