How 0% capital gain rate actually works

[Michael Plaks]

"For the first $40,000 of your income, the capital gain tax rate is 0%! You pay nothing!"

Fantastic, but what does it actually mean?

• If I have no job and sell a property for $100,000 - does it mean I pay nothing for the first $40,000 and then 15% on the remaining $60,000?
• If I have a $50k job and have a $25,000 capital gain from selling stocks - is it tax-free because $25,000 is less than $40,000?

The answers are no and no, so let me try to clarify how this actually works.

IMPORTANT: only long-term gains have these good rates. Short-term (1 yr or less) gains are taxed much higher.

1. The 0% capital gain bracket by itself

We will start with a rare situation of having absolutely no other income but long-term capital gains. 

The first $40k of your taxable capital gain is in this magical 0% tax bracket. Double it to $80k if you're a married couple. By the way, my numbers are rounded; the exact numbers are different and increase slightly every year.

The word taxable is important, because you first subtract your standard deduction of approximately $12k for single folks and $24k for the couples. If you itemized your deductions, then you subtract your itemized deductions instead. You might also have other subtractions known as adjustments, for example student loan interest. Whatever is left is called taxable income.

This means that a single guy with no job or other income can generate $52k in capital gains and pay $0 in taxes. 

For comparison, if he had a $52k job, he would pay $4.5k in income taxes plus another $4k in FICA taxes.

2. Capital gains combined with other income

Now let's give this guy a $52k job and give him capital gain taxes in addition to his job. Does he still get $40k of tax-free capital gains? No, he does not. His taxable income was already at the $40k limit just from his job, so every penny of his capital gain is taxable at 15%.

What if his job income was only $42k? 

• We first subtract $12k standard deduction and arrive at $30k
• This $30k is his taxable income before his capital gains are added
• He now has room for $10k of tax-free capital gains before reaching the $40k ceiling
• If he receives a $100k capital gain, the first $10k is tax-free, and the remaining $90k is taxed at 15%

See how this works? Double all these numbers for married couples filing jointly.

3. What is a capital gain on selling real property?

This is a very complex topic, but I want to show one simplified example here:

• bought a house for $200k
• held it as a rental for a few years and deducted $30k worth of depreciation
• sold the house for $260k
• your capital gain is $90k, of which $60k is from appreciation of the property, and $30k is depreciation recapture

If this house was sold by a retired couple who had no other taxable income for the year, they would still pay zero taxes on the sale! This is because a married couple has a $52k x 2 = $104k (or, if this makes more sense, $80k + $24k = $104k) threshold, and depreciation recapture is a form of capital gain, so it gets rolled into this free zone, too. Sweet.

[David M.]

@Matthew Walker

that's the general idea.  I think technically the depreciation unrecapture rate is 25% or no more than your ordinary rate.  So, the exception would be if you had very little other income.

Only in some rare occasions could you depreciate to zero.  You can only depreciate the improvement value, not the land.  So you use the assessed value of the land and the improvements to determine the ratio which to apply to your purchase price / cost basis to determine your depreciation schedule.

[David M.]

@Daniel Dietz

I see there hasn't been a response.

From my layman's experience, the long term capital gains is effectively in a separate "bucket."  So, having lots of long term capital gain does/should not affect your ordinary tax rate.  Same as if you had to treat lots of qualified dividends.  They get "pulled out" and effectively treated separately, albeit in a very convoluted fashion on the worksheet.

That's just my experience with my tax returns.  Maybe there is a special situation where what you are asking does apply.

Good luck.

[Tushar P.]

@Daniel Dietz capital gains tax rate depends on the ordinary income, not the other way round. Your example is suggesting double taxation.

[Michael Plaks]

Originally posted by @Daniel Dietz:

@Michael Plaks, I am wondering if you could explain it in 'reverse' - meaning how does Capital Gains affect 'regular income' (such as W2) tax rate?

Remember school experiments with heavier and lighter liquids? The heavier syrup will stay at the bottom of the glass, and the lighter water will be at the top. (Feel free to substitute this experiment with its adult version at your nearby bar.)

Ordinary rates are heavier, so the income taxable at the ordinary rate, like W2, stays at the bottom. When you add the lighter taxed capital gains on top of W2, capital gains stay at the top. They do not drop to the bottom and push the W2 income to the top.

As a result, nothing changes as far as taxation of W2 income. You pay the exact same amount of taxes on this income. The extra capital gains are taxed at the capital gain rates. Most likely 15%.

[Michael Plaks]

Originally posted by @Matthew Walker:

I buy a house for 500K and rent it out. I depreciate the house to zero over 27.5 years. I sell the house for 1million. Does this mean I pay tax on 500K sale profit at a 15% rate and tax on the 500K depreciation recapture at a 25% rate?

In a very superficial analysis - yes, you're on the right track. 

In reality, there's a lot of complications:

• you cannot depreciate to zero, as @David M. pointed out
• the capital gain rate will increase at this level of numbers, so different rates will apply to the $500k of appreciation
• depreciation recapture is not a flat rate, 25% is merely its ceiling, so again, different rates will apply to parts of depreciation recapture

No sane accountant will estimate it by hand  and will instead use tax software. You should, too.

[Seidy Lasker]

@Michael Plaks

Can you quitclaim deed a rental property to someone with less income and then have them sell it? Could you avoid capital gains if their income is less than $52,400?

[Michael Plaks]

@Seidy Lasker

QCD is a mechanism of transfer. When you transfer a property to someone else, it has tax consequences for both sides, depending on the nature of the transfer: is it a sale? a gift? etc

[John Woodrich]

Originally posted by @Seidy Lasker:

@Michael Plaks

Can you quitclaim deed a rental property to someone with less income and then have them sell it? Could you avoid capital gains if their income is less than $52,400?

Tax avoidance can get you jail time.  As Michael mentioned, you may be able to gift the property but in most all instances the gift needs to be reported.  Auditor will look at the facts and circumstances, there isn't a "loophole" here. 

[Seidy Lasker]

@John Woodrich

Yeah but there is no tax on the gift if its not over the exclusion amount so if you have capital gains of $50,000 and gifted the property to a family member like a retired person and they sold it for a 50k capital gain, there shouldn’t be any tax on the gain if they’re in the 0% capital gains bracket.

[Seidy Lasker]

@Michael Plaks

Assuming its a gift and the giftee is in the 0% capital gains bracket and the giftor is below the lifetime gift exclusion.

[David M.]

@Seidy Lasker

I think the issue issue is on the transfer you are resetting the cost basis.  Also, the gift is the value of the property, not taxable amount.  Otherwise, what you are saying is if somebody gifted you a used car, there is no gift tax since its obviuoslty worth less than what it was purchased so there is no profit to tax.  Or, if somebody gave you $20k in cold, hard cash.  Aside from macro/microeconomic (whichever) inflation, the face value of bills hasn't changed so why would you have to pay gift tax on $5k (the value over the $15k limit).  make sense?

[Michael Plaks]

Originally posted by @Seidy Lasker:

@Michael Plaks
Assuming its a gift and the giftee is in the 0% capital gains bracket and the giftor is below the lifetime gift exclusion.

Let's have an example so we're not talking about different situations.

You bought a piece of land 5 years ago for $100k. You're selling it for $150k, and you're in a 24% tax bracket. You would have capital gain tax on the $50k appreciation.

You gift this property to your retired parents. The gift is $150k, not $50k, and it does require you to file a gift tax return. No tax for you now, but you're eating into your lifetime estate/gift tax exemption. If you expect to never be above the threshold (which is a moving target, don't forget it), then you don't care.

Your parents inherit your $100k basis. If they sell it, and they are in a 0% tax bracket, there is no tax for them.

Potential problems:

• once you gifted it to them, it is theirs, and they don't have to sell it, and they don't have to give you the $50k profit, either
• if they do give you back the $50k, it has a potential of being busted by the IRS, even though the IRS will probably never know about it
• but if they do, you run a risk (pretty small, but still) of a criminal case against you, which is something I personally would never risk
• the property becomes subject to claims of your parents' creditors. They may have no claims today, but what if tomorrow they run over someone's dog?
• the sale can potentially mess up their government benefits: Soc Security, Sec. 8, stimulus payments etc.
• the sale may prevent then from applying for future benefits like long-term care

I'm sure my list is incomplete, but you get the point.

[John Woodrich]

Originally posted by @Seidy Lasker:

@John Woodrich

Yeah but there is no tax on the gift if its not over the exclusion amount so if you have capital gains of $50,000 and gifted the property to a family member like a retired person and they sold it for a 50k capital gain, there shouldn’t be any tax on the gain if they’re in the 0% capital gains bracket.

Gift is based on the FMV of the asset being gifted. A gift with a $50k gain would be over the annual exclusion amount. As I mentioned, you may be able to file a gift return to report the gift but it has to be a gift. If you gift the money back to the original person tax evasion is pretty clear.

I had someone who wanted me to file a return with a gift of appreciated property, transferred via a QC deed.  Grandson sold it a month later, no gift tax returns were filed and I heard mentions of it being more of a loan to the grandson.  I wasn't going to put my name on the returns.
  

[Henry Ham]

Great info here sir thank you for sharing

[Terry Wheeland]

@Michael Plaks Is it safe to say that if you are selling a rental property this year and not doing a 1031, and you know your overall income will increase in 2022, then it would make sense to sell before the end of 2021 and take the tax consequences at your lower overall income rate?

[Michael Plaks]

Originally posted by @Terry Wheeland

No, it is not safe. There's much more at play than your overall income, so it is very possibly not apples to apples. It depends on what this income consists of and on other factors. Not to mention that you never know the future, as Covid reminded us.

More importantly, you should never make business decisions such as selling a property based on taxes. Sell the property whenever it is the right time to sell, the right buyer comes along and so on. After your decision is made, then explore whether you can reduce taxes on the pending transaction. But not the other way around.

[Sam Dalton]

@Michael Plaks I have a condo that I have lived in for 5 years and only rented it out for the last 18 months. Would I still get hit with Capital Gain Tax since I lived in it for 2 out of the last 5 years? I’m married and file jointly.

[Jonn Vidal]

What is the timeframe between short and long?

[Nat Serrano]

What if I don’t have any w2 income in the year I sell, but I receive 60k in revenue from a property I own but actual cashflow a year is 12k. Will I have to pay capital gain taxes?