The Tax Cuts and Jobs Act of 2017 (TCJA) did not make any major changes to the taxation of gains and losses from securities transactions. Favorable tax rates continue to apply to capital gains, and losses continue to be used as offsets to capital gains and a limited amount of ordinary income. There are, however, numerous changes made that affect the taxation of securities investors, some directly and some indirectly. This article is a roundup of these changes.
Tax Rates on Capital Gains
The TCJA did not change the rates on long-term capital gains and qualified dividends. The rates remain at zero, 15%, or 20%, depending on the individual’s taxable income (which does not align with tax brackets). The zero rate applies for taxable income below a set amount; the 20% rate applies for taxable income over a threshold amount. For 2018, the breakpoints are as follows:
- Married filing jointly and surviving spouses: Zero for taxable income not exceeding $77,200; 20% for taxable income over $479,000
- Heads of households: Zero for taxable income not exceeding $51,700; 20% for taxable income over $452,400
- Singles: Zero for taxable income not exceeding $38,600; 20% for taxable income over $425,800
- Married filing separately: Zero for taxable income not exceeding $38,600; 20% for taxable income over $248,500.
For example, in 2018 a married couple could have income plus long-term capital gains (assuming no capital losses) of up to $101,200 ($77,200 taxable income limit for 0% tax rate + $24,000 standard deduction) before the capital gains would be taxed.
For children subject to the kiddie tax, the taxable income breakpoints for trusts and estates governs whether they pay 0%, 15%, or 20% on their long-term capital gains [Internal Revenue Code (IRC) section 1(j)(4)]. More specifically, the 0% rate applies only if taxable income in 2018 is not more than $2,600; the 20% rate applies once taxable income exceeds $12,700.
Higher capital gains rates.
The higher rates of 25% for certain depreciated property (technically unrecaptured IRC section 1250 gain) and 28% for collectibles continues to apply post-TCJA. The new ordinary income tax rates set by the TCJA apply to net short-term capital gains; these rates are 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
Deferral option eliminated.
Until now, if an investor had a capital gain on the sale of publicly traded securities, gain could be deferred by investing the proceeds within 60 days in common stock or a partnership interest in a specialized small business investment company (SSBIC) (IRC section 1044). The TCJA repealed this deferral opportunity for sales after 2017.
Carried interest rule.
For fund managers who have capital gains passed through to them from their partnerships according to a profits interest in exchange for management services, a new carried interest rule applies. They must meet a three-year holding period to qualify for capital gain treatment [IRC section 1061(a)]. If this holding period is not met, then capital gains are treated as short-term and taxed as ordinary income. The IRS has announced that S corporations are subject to the extended three-year holding period applicable to partnerships (Notice 2018-18, IRB 2018-12, 443).
Tax Treatment of Capital Losses
Capital losses can be used to offset capital gains for the year. If there are excess losses, they can offset up to $3,000 of ordinary income, such as salary or interest income ($1,500 if married filing separately). Any unused capital losses can be carried forward indefinitely to offset capital gains (and the limited amount of ordinary income) in subsequent years. This dollar amount has been in place since 1978; it was not changed by the TCJA.
Higher-income investors may have to pay an additional Medicare tax of 3.8%, referred to as the net investment income (NII) tax. More specifically, this tax applies to the lesser of NII or the amount that modified adjusted gross income (MAGI) exceeds a statutory amount:
- Married filing jointly and surviving spouse: $250,000
- Single or head of household: $200,000
- Married filing separately: $125,000.
For securities investors with MAGI over the applicable statutory amount who are subject to the NII tax, the capital gains rate effectively becomes 18.8% (15% + 3.8%) or 23.8% (20% + 3.8%), depending on their taxable income. The TCJA did not make any changes to the NII tax; the statutory amounts are not adjusted annually for inflation.
Investment interest, such as interest on loans to buy securities, remains deductible; however, due to the increase in the standard deduction amount, fewer individuals are likely to itemize.
Commissions to buy and sell securities are not separately deductible. Commissions to buy securities become part of basis; those to sell securities effectively reduce proceeds (the sales price). Other investment-related expenses, however, such as advisory fees (e.g., a 1% managed account fee), safe deposit box rentals to store securities, and subscriptions to investment letters, magazines, and online services, are no longer deductible. The TCJA suspended from 2018 through 2025 the deduction for miscellaneous itemized expenses subject to the 2% of adjusted gross income floor [IRC section 67(g)].
Investment interest, such as interest on loans to buy securities, remains deductible for those who itemize deductions to the extent of investment income (which usually does not include capital gains). The TCJA did not directly change this itemized deduction; however, due to the increase in the standard deduction amount, fewer individuals are likely to itemize.
Qualified Business Income Deduction
The new 20% deduction for owners of pass-through entities is impacted by their capital gains (IRC section 199A). More specifically, the deduction cannot be more than an owner’s taxable income reduced by net capital gains for the year. Additional IRS guidance is needed to flesh out the scope of this limitation and what it means for owners who are also securities investors.
There are a number of proposals before Congress that could change the taxation of capital gains (for 2018 or future years, depending upon effective date). These include aligning the 0%, 15%, and 20% rates for capital gains with tax brackets (as was done in the past rather than with different taxable income amounts) and indexing for capital assets (e.g., Capital Gains Inflation Relief Act of 2018; S. 2688). Whether these or any other changes will be enacted remains to be seen. In addition, further IRS guidance on the TCJA changes may affect the taxation of securities investors.