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.
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.
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