Tax Law Blog: Fiscal Cliff Deal Adjusts Capital Gain Rates and Qualified Dividend Rates

by Davis Brown Law Firm
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In order to avoid the dreaded fiscal cliff, Congress passed an eleventh hour “fix” titled, “The American Taxpayer Relief Act of 2012” (“TATRA”). Bill Watterson’s character Calvin, from Calvin and Hobbs, once stated, “A good compromise leaves everybody mad”. Perhaps, then, TATRA is a good compromise bill. It benefits a large amount of Americans and for those it does not benefit, their tax costs could have been much greater.

However, there is also plenty to be upset about on both sides and there were clearly some winners and losers among the special interest tax items. For instance, the Mine Rescue Training Credit survived, but the Adoption Tax Credit went the way of the buffalo. Likewise, higher income taxpayers will pay higher rates, but the estate tax exemptions (see other blog posts) remained at historically high thresholds.

There has been much debate over the course of the last few months as to what capital gain rates and dividend rates would be in the next year. The author of this blog was fairly certain that dividend rates would rise significantly, while capital gain rates would remain at 15% for some taxpayers and increasing to 20 or 25% for all others. At least on one account my prognostications were correct.

Capital gain rates remain at 15% for taxpayers whose taxable income and/or adjusted net capital gain is under the $400,000/$450,000 (single/married filing jointly) thresholds. For those with taxable income and/or adjusted net capital gains in excess of those thresholds those capital gains will be taxed at 20%. The 0% capital gain rate survives as well and was not mentioned or amended by TATRA. Here is how this will work out in practice:

  1. Joe files married filing jointly and is retired with no ordinary income. Throughout the year, Joe sells off farmland and has $500,000.00 worth of adjusted net capital gains. Because he has no ordinary income, the adjusted net capital gains are used to determine what ordinary income rates would apply and, thus, what capital gain rates apply. For the first $72,500 of capital gain, Joe will pay a 0% rate on the capital gains. For the amount of capital gains exceeding that amount and up to $450,000.00, the capital gain rate will be 15%, leaving the remainder to be taxed at the new 20% rate. Thus on the $500,000.00, Joe will pay $66,625.00 - an effective tax rate of 13.3%. 

  2. John, a single filer, has total taxable income of $415,000.00 which includes adjusted net capital gains of $10,000.00. Because John has taxable income which exceeds the new “high income individual” rate (39.6%) and ordinary income is counted first in determining what capital gain rate is applicable, John will pay taxes of $2,000.00 or 20% on the $10,000.00 of capital gains. John will pay the graduated income tax rates on the remainder of the ordinary income. Conversely, if John had only $395,000.00 in ordinary income, John would pay the 15% capital gain on the first $5,000.00 of his adjusted net capital gains.

The qualified dividend rate was not mentioned by TATRA and will therefore remain tied to capital gain rates. Under previous law, qualified dividends were taxed as adjusted net capital gains. TATRA did not change this, and as such, qualified dividends will be taxed at the same rates as capital gains and in the same manner. The above illustrations would not change in any significant degree if the capital gain income were made up of both capital gains and qualified dividends.

While it is tempting to believe that these are the rates that will stick around for a while, and TATRA does make them permanent, it should be noted that there is a lot of bargaining to take place over the next few months and it would not be surprising if further tax changes were made as part of other concessions. For now, it seems as though we finally have some clarity heading into 2013.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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