IRS Clarifies Net Capital Gains in Final 199A Regulations

Good news! The IRS in its final regulations on the new 20 percent tax deduction under Section 199A clarified what capital gains are for Section 199A.  Sadly, they include more downside than we had hoped. But clarity is worth a ton. And with the final regulations, the IRS has given clarity to the capital gains component of the Section 199A tax deduction.

The Section 199A tax deduction applies to your trade or business income from a pass-through entity such as a proprietorship, rental property, trust, estate, partnership, or S corporation. When taxable income is equal to or less than the threshold of $315,000 (married, filing jointly) or $157,500 (filing as single or head of household), your Section 199A tax deduction is the lesser of your

  • taxable income reduced by net capital gains, or
  • qualified business income as explained in IRS Issues Final Section 199A Regulations and Defines QBI.

New Regulation

The final regulations provide a definition of net capital gain that reads as follows:1 Net capital gain means net capital gain as defined in section 1222(11) plus any qualified dividend income (as defined in section 1(h)(11)(B)) for the taxable year. 2 Yes, we know that’s very technical, but bear with us for a moment and we’ll make this clear. But first, the tax code.

IRC Section 199A(a)(2)

As you likely know, the tax code is the supreme commander in tax law. When computing your new 20 percent tax deduction, Section 199A(a)(2) of the tax code tells you to reduce your taxable income by your net capital gain as defined in IRC Section 1(h).

Okay, so now you have both the code and the regs.

What Do the Code and Regs Mean?

Simple version. For the Section 199A calculation, your net capital gains are

  • all net capital gains taxed at a preferred tax rate, plus
  • dividends that are taxed at preferred capital gains rates.

Example. Sam has $200,000 of taxable income, $12,000 of unrecaptured Section 1250 capital gain from the sale of a rental property, and $13,000 of long-term capital gains from the sale of that rental. For Section 199A purposes, Sam applies the 20 percent deduction to a taxable income ceiling of $175,000 ($200,000 – $12,000 – $13,000).

What happens here is that IRC Section 1222(11) gathers the net capital gains and throws them into IRC Section 1(h), where they are disaggregated and taxed as long-term gains, unrecaptured Section 1250 gain, 28 percent gain, etc.

(Frankly, capital gains taxation is a difficult process that neither taxpayers nor tax professionals would tolerate without computers.)

Takeaways

With this IRS clarification in the final regulations, your net capital gains that reduce your taxable income for the Section 199A tax deduction are those (a) net capital gains and (b) dividend income that already benefit from lower tax rates.

Before the IRS clarification in the final regulations, dividends were likely not considered as reducing taxable income for Section 199A purposes.

Regardless of whether you like the final regs, you have to admit that clarity is worth a lot.