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.