Capital Gains Tax Rates

Why This Matters

Capital gains taxation sits at the heart of tax planning strategy, and you'll be tested on your ability to distinguish between rate structures, holding period requirements, and special asset categories. The exam expects you to understand not just what the rates are, but why Congress created preferential rates for certain types of gains—encouraging long-term investment, supporting small businesses, and recapturing prior tax benefits like depreciation deductions.

The key concepts here include holding period distinctions, preferential rate structures, recapture provisions, and income-based phase-ins. Don't just memorize that long-term gains get better rates—know which assets qualify, what thresholds trigger higher rates, and how special provisions like QSBS exclusions and Section 1250 recapture interact with the basic framework. When you see a fact pattern on the exam, you're being asked to apply the right rate to the right gain.

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Standard Rate Framework: Short-Term vs. Long-Term

The fundamental distinction in capital gains taxation is the holding period. Congress intentionally rewards patient investors with lower rates, creating a two-tier system that drives most tax planning decisions around the timing of asset sales.

Short-Term Capital Gains (Ordinary Income Rates)

• Taxed at ordinary income rates (10%–37%)—no preferential treatment, same brackets as wages and salaries
• Applies to assets held one year or less—the holding period is measured from the day after acquisition through the sale date
• Stacks on top of other income—short-term gains can push taxpayers into higher marginal brackets, making timing critical

Long-Term Capital Gains (Preferential Rates)

• Three-tier rate structure: 0%, 15%, or 20%—determined by the taxpayer's taxable income level, not the size of the gain
• Requires holding period exceeding one year—"more than" is key; exactly 365 days still qualifies as short-term
• 0% rate available to lower-income taxpayers—applies to those in the 10% and 12% ordinary income brackets, creating planning opportunities

Holding Period Requirements

• Begins the day after acquisition, ends on sale date—this "day after" rule is frequently tested
• Inherited property is automatically long-term—regardless of how long the decedent held it, beneficiaries get preferential rates
• Wash sale and related party rules can affect holding periods—be alert to fact patterns involving repurchases or family transactions

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Additional Taxes on Investment Income

Beyond the basic rate structure, high-income taxpayers face an additional layer of taxation designed to fund healthcare programs. Understanding when NIIT applies is essential for calculating total tax liability on investment income.

Net Investment Income Tax (NIIT)

• Additional 3.8% surtax on net investment income—applies on top of regular capital gains rates, potentially bringing the effective rate to 23.8%
• Triggered by MAGI thresholds: $\$200,000$ (single) or $\$250,000$ (MFJ)—these thresholds are not indexed for inflation
• Applies to capital gains, dividends, interest, rental income, and passive activity income—wages and self-employment income are excluded from the NII base

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Special Asset Categories: Higher Maximum Rates

Not all long-term capital gains receive the standard preferential rates. Certain asset categories carry higher maximum rates, either because of recapture provisions or the nature of the asset itself.

Collectibles (28% Maximum Rate)

• Maximum rate of 28% regardless of income level—applies to art, antiques, coins, stamps, gems, and most precious metals
• Only applies to gains held long-term—short-term collectible gains are still taxed at ordinary rates (potentially higher than 28%)
• Includes certain gold and silver ETFs—not all investment vehicles qualify for standard long-term rates

Section 1250 Depreciation Recapture

• Maximum 25% rate on unrecaptured Section 1250 gain—applies to real property where depreciation was previously deducted
• Recaptures the tax benefit of prior depreciation deductions—the government "claws back" some of the benefit when property is sold at a gain
• Only the depreciation portion is recaptured at 25%—any gain above the original cost basis is taxed at standard long-term rates (0%, 15%, or 20%)

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Preferential Exclusions and Deferrals

Congress has created several provisions that go beyond reduced rates to offer partial or complete exclusion of capital gains, typically to encourage specific economic behaviors like small business investment or real estate reinvestment.

Qualified Small Business Stock (QSBS) Exclusion

• Up to 100% exclusion of gain if held more than five years—potentially zero federal tax on qualifying gains
• Exclusion capped at greater of $\$10$ million or 10× adjusted basis—significant but not unlimited benefit
• Strict qualification requirements—must be original issue stock from a domestic C corporation with gross assets under $\$50$ million, engaged in active business

Special Real Estate Investment Provisions

• Qualified Opportunity Funds offer deferral plus partial exclusion—invest capital gains within 180 days, defer recognition, and potentially exclude appreciation if held 10+ years
• Section 1031 like-kind exchanges defer gain entirely—no current tax if proceeds are reinvested in qualifying replacement property
• REITs pass through capital gains to shareholders—taxed at shareholder level, maintaining character as capital gain

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Dividend Treatment: Quasi-Capital Gains

Qualified dividends receive the same preferential rates as long-term capital gains, blurring the line between these two income categories for tax purposes.

Qualified Dividends

• Taxed at 0%, 15%, or 20%—identical to long-term capital gains rates, determined by taxpayer's income level
• Must meet holding period requirement—stock must be held more than 60 days during the 121-day period surrounding the ex-dividend date
• Must be paid by U.S. or qualified foreign corporation—dividends from REITs, money market funds, and certain foreign entities don't qualify

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State-Level Considerations

Federal rates tell only part of the story. State taxation can significantly impact total tax liability on capital gains, and the treatment varies widely across jurisdictions.

State Capital Gains Tax Rates

• Most states tax capital gains as ordinary income—no preferential rate at the state level, adding 0%–13%+ depending on residence
• A few states offer reduced rates or exclusions—some provide partial exclusions for in-state investments or long holding periods
• Nine states have no income tax—capital gains escape state taxation entirely in these jurisdictions, creating planning opportunities for mobile taxpayers

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Quick Reference Table

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Self-Check Questions

1. A taxpayer sells stock held for exactly 365 days at a gain. Is this gain taxed at short-term or long-term rates, and why does the specific day count matter?

2. Compare the tax treatment of a $\$50,000$ gain on collectible coins versus a $\$50,000$ gain on publicly traded stock, assuming both were held for three years by a high-income taxpayer subject to NIIT.

3. A real estate investor sells a rental property for $\$500,000$ that had an original cost of $\$400,000$ and accumulated depreciation of $\$80,000$. Which portions of the gain are taxed at which rates?

4. What three requirements must dividends meet to qualify for preferential tax rates, and how does the holding period test differ from the long-term capital gains holding period?

5. If an FRQ asks you to calculate the maximum federal tax rate on a high-income taxpayer's long-term capital gain from selling corporate stock, what rate should you use and why might it differ from the statutory 20% rate?