Percentage Exclusions and Alternative Tax Rates for Realized Capital Gains

Owners of assets that have appreciated in value have a strong incentive to hold them longer than they would otherwise rather than realize a gain on the assets and pay tax. That phenomenon--known as the lock-in effect--occurs because the effective tax rate on an accrued gain declines the longer the tax is deferred (and becomes zero when the owner dies). Soon after the income tax was initiated in 1913, statutory tax rates increased, and the lock-in effect became quite large. To try to induce more realizations, the Congress began in 1922 to establish lower statutory rates for capital gains. It has also enacted other measures that attempt to roughly offset the taxation of gains that are attributable solely to inflation.

Over the years, the Congress has tried to reduce the effective tax rate on capital gains by excluding a percentage of the gains from taxable income and legislating alternative statutory rates (see the table below). The lower effective rates occasionally depended on such factors as how long the asset had been held or the taxpayer's marginal tax bracket after excluding capital gains. Only between 1988 and 1990 were capital gains taxed at the same effective rate as regular income.

Capital Gains Tax Treatment

       
Period Gains Excluded
from Income (Percent)		   Maximum Tax Rate on
Included Gains (Percent)
1913 to 1921 0   Same as ordinary rates
1922 to 1933 50 or 12.5
1934 to 1937 20 to 70a   Same as ordinary rates
1938 to 1941 50 and 30
1942 to 1951 50 or 25
1952 to 1953 50 or 26
1954 to 1967 50 or 25
1968 50 or 26.875
1969 50 or 27.5
1970 50 or 30.2
1971 50 or 32.5
1972 to Sept. 1978 50   Same as ordinary rates
Oct. 1978 to June 1981 60   Same as ordinary rates
June 1981 to Dec. 1981 60 or 20
1982 to 1986 60   Same as ordinary rates
1987 0   28
1988 to 1990 0   Same as ordinary rates (28 percent)
1991 to 1992 0   28.9
1993 to 1996 0   29.2
1997 to May 2003 0   21.2
May 2003 to Dec. 2005 0   16.1
2006 to 2007b 0   15.7
2008b 0   15.4
2009b 0   20.4
2010b 0   20
2011 onb 0   21.2
Sources: Leonard Burman, The Labyrinth of Capital Gains Tax Policy (Washington, D.C.: Brookings Institution Press, 1999), and Citizens for Tax Justice, available at www.ctj.org/pdf/regcg.pdf.
a. Depending on the holding period.
b. Assuming the tax law in effect on January 1, 2006.

Under current law, gains on assets that are held for more than one year are taxed at lower rates than those that apply to other income. Taxpayers in the 15 percent tax bracket or lower pay 5 percent on capital gains (the rate falls to 0 in 2008, and then increases to 10 percent in 2009); taxpayers in higher brackets pay 15 percent (with the rate increasing to 20 percent in 2009). Because of their interaction with various phaseouts, the maximum effective rates actually are slightly higher.(1)

1.  Taxpayers with assets purchased before 2001 can also benefit from the lower rates by paying deferred taxes--at the higher rates--as if a sale had occurred in 2001. If the asset is then held for five more years, any taxes on subsequent gains will be at the lower rates.