by JAY WILDER – October 17, 2018
I’m on the lookout for unexpected, non-intuitive outcomes of the Trump tax bill. Here’s one that has not been covered in the news – higher taxes on long-term capital gains in a specific income/deduction range. If you meet the following criteria:
- Are married
- Have take-home earnings (salary minus payroll deductions) in the neighborhood of $100,000
- Have itemized deductions of around $25,000, including about $10,000 in state and local taxes
- Have long-term capital gains
…then you will pay significantly higher taxes on those capital gains under the new law than you would have under the old law. Let’s look at why.
We’ll start with some background. The long-term capital gain tax curve looks like this.
The Y axis gives the tax rate for each dollar earned, so it starts at 0% and then jumps up to 15%. But to explain the X-axis – because it’s a little confusing – this does not mean that your first long-term capital gains dollar is always taxed at 0%. Your take-home earnings minus your exemptions and deductions determines where on the graph your starting position is. So, if you have $100,000 in take-home earnings and $10,000 in deductions, your first long-term capital gains dollar starts at $90,000, so is taxed at 15%. In a different scenario, if you have $80,000 in salary and $10,000 in deductions, you start on the above curve at $70,000, so your first long-term capital gains dollar is taxed at 0%. In this scenario, if you have enough long-term gains, some will be taxed at 0% and then some will be taxed at 15% as soon as you cross the $77,400 threshold. Make sense?
Because the marginal tax rates for long-term gains below $400,000 did not change with the new tax law, most people would assume that the amount of long-term capital gains taxes would not change. This is incorrect. Why? Because of the trickle-down effect of changes to deductions and exemptions. Let’s use a worst-case scenario to show how the calculations work:
| 2018 – No Trump | 2018 – with Trump | |
| Earnings after payroll deductions | $101,700 | $101,700 |
| Exemptions | $8,300 exemption for husband + wife | $0 (these were eliminated) |
| State and Local Tax deductions | $12,000 | $10,000 (capped at $10K under new law) |
| All other deductions (mortgage interest, charity, medical, etc.) | $14,000 | $14,000 |
| Starting point on long-term capital gains curve | $67,400 ($101,700 – $8,300 – $12,000 – $14,000) | $77,700 ($101,700 – $10,000 – $14,000) |
| Capital Gains | $10,000 | $10,000 |
| Taxes on Capital Gains | $0 ($10,000 * 0%) | $1,500 ($10,000 * 15%) |
We’ll show this on the marginal tax rate graph. One way to think of it is that changes to deduction/exemption law push the starting point of the tax rate calculation to the right. So instead of starting at $67,400 (and paying 0%, represented by the red line), you would start at $77,700 (and pay 15%, represented by the orange bar).
The above example is the most extreme (where the tax rate for the entire amount jumped from 0% to 15%), but anyone in this ballpark may be impacted to a lesser extent. This certainly counts as a middle-class tax increase, and reinforces the lesson that a complex law passed too quickly will have unexpected and undesirable downstream effects.