EA Part 1 Capital Gains and Losses: Netting Rules and Tax Rates

Capital gains and losses appear on almost every EA Part 1 exam. The mechanics — holding periods, netting rules, rate tiers, and loss carryovers — are tested both in isolation and embedded in broader income questions. Getting these right requires precision, not just a general sense of the rules.

Short-Term vs. Long-Term: The Holding Period

A capital asset is held long-term if it is held for more than one year (more than 12 months). If sold on the one-year anniversary of purchase, it is still short-term — the holding period must exceed one year.

Counting the holding period: Start counting from the day after the acquisition date and include the day of sale. For example, an asset purchased on March 15, 2023, must be sold on March 16, 2024, or later to be long-term.

Special holding period rules:

• Inherited property is automatically treated as long-term, regardless of how long the decedent or beneficiary held it
• Like-kind exchange property carries over the holding period of the exchanged property if the property given up was a capital asset or §1231 asset held long-term
• Gifted property: the donee takes the donor's holding period if the donor's basis is used to determine gain

Long-Term Capital Gains Tax Rates

Long-term capital gains (LTCG) are taxed at preferential rates — 0%, 15%, or 20% — depending on the taxpayer's taxable income. For 2024:

Filing Status	0% Rate Up To	15% Rate Up To	20% Above
Single	$47,025	$518,900	Over $518,900
MFJ	$94,050	$583,750	Over $583,750
HOH	$63,000	$551,350	Over $551,350
MFS	$47,025	$291,850	Over $291,850

Short-term capital gains are taxed as ordinary income at the taxpayer's marginal rate.

Unrecaptured §1250 gain (depreciation recapture on real property) is a special category of long-term gain taxed at a maximum rate of 25%.

Collectibles gain (art, stamps, coins, antiques, precious metals held as investments) is taxed at a maximum rate of 28%.

The Net Investment Income Tax (NIIT) of 3.8% applies to net investment income — which includes capital gains — for taxpayers with modified AGI above $200,000 (single) or $250,000 (MFJ). This is in addition to the regular capital gains rate.

The Capital Gain and Loss Netting Process

The IRS requires a specific netting sequence before you can determine the tax treatment of capital transactions.

Step 1: Separate all capital gains and losses into short-term and long-term groups.

Step 2: Net within each group. Sum all short-term gains and losses to get a net short-term gain or loss (NSTG/NSTL). Do the same for long-term (NLTG/NLTL).

Step 3: If both groups produce the same type of result (both net gains, or both net losses), no further netting occurs. Each retains its character:

• NSTG is taxed as ordinary income
• NLTG is taxed at preferential rates

Step 4: If one group produces a net gain and the other a net loss, net them against each other. The result takes the character of the larger group. For example, a $5,000 NLTG netted against a $2,000 NSTL produces a $3,000 net long-term capital gain taxed at preferential rates.

The $3,000 Capital Loss Deduction Limit

If total capital losses exceed total capital gains, the excess loss is deductible against ordinary income up to $3,000 per year ($1,500 for MFS). This applies regardless of whether the net loss is short-term or long-term.

Carryover: Unused capital losses carry forward indefinitely to future tax years. They retain their short-term or long-term character in the carryover. A taxpayer who carries over losses must use them in the next year — they cannot choose to skip a year.

Example: A taxpayer has a $15,000 net capital loss. They deduct $3,000 in year one and carry forward $12,000. In year two, they have a $4,000 long-term capital gain. The carryover ($12,000 long-term loss) first offsets the $4,000 gain, leaving $8,000 still carried forward.

Section 1231 Assets: A Brief Overview

Section 1231 assets are depreciable property and real property used in a trade or business held for more than one year. The tax treatment is hybrid:

• Net §1231 gains are treated as long-term capital gains (taxed at preferential rates)
• Net §1231 losses are treated as ordinary losses (fully deductible, not subject to the $3,000 limit)

This asymmetric treatment is favorable, but there's a recapture rule: if a taxpayer has had §1231 losses in the prior 5 years, current year §1231 gains are recharacterized as ordinary income until those prior losses are fully recaptured.

Depreciation recapture on §1245 property (most personal property) is always ordinary income, not capital gain.

Common Exam Traps

Trap 1: A wash sale occurs when a taxpayer sells a security at a loss and buys substantially identical securities within 30 days before or after the sale. The loss is disallowed and added to the basis of the new shares. The holding period of the disallowed loss shares carries over.

Trap 2: The holding period starts the day after purchase — not the day of purchase. Questions that ask you to count holding periods often set traps at exactly the 12-month mark.

Trap 3: Inherited property always gets a stepped-up (or stepped-down) basis to fair market value on the date of death, and it is automatically long-term. This rule applies even if the decedent purchased the asset the day before death.

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