Recent changes to the Internal Revenue Code of 1986, as amended (the "Code"), allow certain individual taxpayers to avoid paying federal income tax on a portion (and in some cases all) of their long-term capital gain and dividend income.
Under Section 1(h) of the Code, certain long-term capital gains and qualified dividends are subject to federal income tax at a 15% rate. Qualified dividends, generally, include dividends from stock of domestic corporations and certain foreign corporations where the stock has been held for more than 60 days. Section 1(h)(1) of the Code, however, provides that after 2007 some or all of these long-term capital gains and qualified dividends may not be subject to federal income tax. To qualify for the 0% rate, the taxpayer's income (other than capital gain and qualified dividend income) must be less than $32,550 for single taxpayers in 2008, and $65,100 for married taxpayers in 2008.
To determine the amount of long-term capital gains and qualified dividends subject to a 0% rate, taxpayers must first determine their "adjusted net capital gain." Generally, a taxpayer's adjusted net capital gain is the taxpayer's net capital gain less gain attributable to sales of collectibles, certain small business stock, and unrecaptured Section 1250 gain, plus qualified dividends. The adjusted net capital gain is then subtracted from total income. If the result is less than $65,100 ($32,550 for single taxpayers), the spread between that result and $65,100 is not subject to tax.
Example 1: Cliff and Clair, married taxpayers filing joint returns, have $225,000 of taxable income in 2008; $50,000 is attributable to wages, $100,000 is attributable to long-term capital gain, and $75,000 is attributable to qualified dividends. Cliff's and Clair's "adjusted net capital gain" is therefore $175,000. Because taxable income reduced by the adjusted net capital gain ($50,000) does not exceed $65,100, some of the capital gain will be taxed at the 0% rate. The amount of adjusted net capital gain taxed at the 0% rate is the excess of $65,100 over $50,000, or $15,100. The other $159,900 of adjusted net capital gain will be taxed at the 15% rate.
Example 2: Sondra and Elvin, married taxpayers filing joint returns, have $160,000 of taxable income in 2008; $80,000 is attributable to wages, $50,000 is attributable to long-term capital gain, and $30,000 is attributable to qualified dividends. Sondra's and Elvin's "adjusted net capital gain" is therefore $80,000. Because taxable income reduced by the adjusted net capital gain ($80,000) exceeds $65,100, none of the adjusted net capital gain will be taxed at the 0% rate.
Example 3: Theo, a single taxpayer, has $230,000 of taxable income in 2008; $25,000 is attributable to wages, $80,000 is attributable to long-term capital gain, and $125,000 is attributable to qualified dividends. Theo's "adjusted net capital gain" is therefore $205,000. Because taxable income reduced by the adjusted net capital gain ($25,000) does not exceed $32,550, some of the capital gain will be taxed at the 0% rate. The amount of adjusted net capital gain taxed at the 0% rate is the excess of $32,550 over $25,000, or $7,550. The other $197,450 of adjusted net capital gain will be taxed at the 15% rate.
If you have any questions about this or other issues relating to the federal income taxation of long-term capital gains or qualified dividends, please contact your tax advisor.
