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In this example we have Carla,

who has a short-term capital loss

of $12,000, a short-term

capital gain of $5,000,

a long-term capital gain from

a stock sale of $6,000, and

a section 1231 gain of $1,200.

How are the above gains and losses netted together?

At what tax rates are the items taxable or deductible?

First, let's review our three steps to set up the gains and losses for

the netting procedure.

First, we simply categorize the gains and losses in the appropriate type,

whether short-term, or long-term, or section 1231.

Second, we net any individual gains and

losses within each category to get one net number.

Third, we net across categories, moving from left to right, using our netting map.

So let's work with our example, using the netting map as the background.

Note now we've added a Section 1231 column on the leftmost side.

But we still have our familiar Short-Term Capital Gain or Loss category, our three

Long-Term Capital Gain categories, and our Ordinary Income or Loss category.

First let's just start with a new item in this example, the Section 1231 item.

Here, Carla has a Section 1231 gain of $1,200.

Our first step is to simply put it in the appropriate column.

As I'm sure you guessed,

we put this $1,200 Section 1231 gain in the Section 1231 column.

Next, Carla has a short-term capital loss of $12,000,

what do we do with this $12,000?

Well, we place it in the Short-Term Capital column.

Next, she has a short-term capital gain of $5,000,

which column does this go into?

Well, you guessed it,

we place the $5,000 gain also in the Short-Term Capital column.

Next, Carla has a long-term capital gain from the stock sale of

$6,000, where does that go?

Well, since this is a stock sale, we'll take that $6,000 and

place it in the 0/15/20% column.

Okay, so we've placed the gain and loss items in the right categories.

The second step of the ordering procedure is to net within each column so

that we're left with only one number in each column.

Let's first net the Section 1231 column.

Well, there's only one number here, so we keep $1,200.

Now if there was also a separate loss in the Section 1231 column,

we would just net the gain with the loss, but

here we just have a net Section 1231 gain.

Next, the Short-Term Capital column.

We have a $12,000 loss and a $5,000 gain, so we can net them together.

We're left with a $7,000 net short-term capital loss.

We now move to the last Long-Term Capital column, and again,

there's only one number here.

So we keep the $6,000 gain in the 0/15/20% column.

So not much else left to net within each column, so

we're done with step two of the ordering procedure.

We have one net number in each column.

Our third step now is to net across columns,

moving from left to right using our netting map directions.

So we start with the Section 1231 column.

The netting map says that if we have a net section 1231 gain,

this number moves to the 0/15/20% Long-Term Capital Gain column.

Note that there's no lookback loss issue here, so we don't have to worry

about reclassifying any of this net 1231 gain as ordinary income.

So we take this $1,200, and

move the entire amount directly into the 0/15/20% column.

We will add it to the $6,000, and now we have $7,200 total in the 0/15/20% column.

Now because we moved the Section 1231 amount out of the Section 1231 column,

nothing is left there, so we move to the right one column.

So next we'll look at the Short-Term Capital Gain or Loss Column.

Notice here we have a $7,000 net short-term capital loss.

Also note that the long-term capital items have a gain.

That is, they're of opposite sign as a short term loss item.

Therefore we can net the short-term items with the long-term items.

So we have this $7,000 net short-term capital loss,

and we move it to the 0/15/20% column.

We net it with a $7,200 net long-term capital gain, and

we're left with $200 net long-term capital gains.

Given that this is a gain, and we're in the 0/15/20% column,

we do not take it over one more column to be taxed at ordinary rates.

That is because we're left with a long-term capital gain,

it should get preferential tax rate treatment.

Therefore, this $200 will be taxed at 15%.

Now, why do we tax it at 15% specifically, and not 0% or 20%?

Well, we tax it at 15% because Carla's ordinary tax rate is 33%.

In other words,

it is not one of the lowest to ordinary tax rate brackets of 10% or 15%.

Therefore, she doesn't get the 0% preferential tax rate.

Nor is the 33% rate the highest ordinary tax rate of 39.6%,

which would otherwise get the 20% preferential tax treatment.

Instead, Carla is somewhere in between the bottom two ordinary tax rate brackets,

and the top ordinary tax rate bracket.

Therefore, she will have a 15% tax rate applied to her long-term capital gains.

Okay, now a small twist.

What happens if we assume all the same facts,

except that Carla has qualified dividends of $250 that she earned from the stock?

Can the $250 qualified dividend offset any of the losses, or be added to the gains?

Here, the answer is technically no,

the dividend income cannot offset any of the short-term capital loss.

And technically, we do not add it to the long-term capital gains either.

Now it just so happens that the $250 dividend will also be taxed

at the same preferential rate of 15%, but

technically it doesn't appear anywhere on the netting map.

Okay, let's ignore the dividends, but add one new fact to our example.

Let's also say that Carla has $150 of Section 1231 lookback

losses that were deducted in the last five years as an ordinary loss.

How do we deal with these prior year losses?

Well, we have to turn back to our netting map and do our ordering procedure.

That is, we have to first put everything in the right column, then net within

each column, and then net across the columns moving from left to right.

So let's start off with putting everything in the right column.

These are all the same facts, so I already have the correct classifications.

In the next step we net within each column, also same numbers as before.

So what about this lookback loss?

Well, we only consider the lookback loss in the case where we

have a net Section 1231 gain in the current year.

So we have to do everything up to netting within each column before considering

the lookback loss.

This is important because it could be the case that in the current year,

we may have a net Section 1231 loss.

If this were the case, then the lookback loss is actually irrelevant.

If we have a current year Section 1231 loss, we would just then move that loss

to the Ordinary column when we net across columns, and simply deduct it.

But here, we have a net Section 1231 gain in the current year.

So what this means, is that when we want to net across columns next,

we have to reclassify some of this gain as ordinary income.

Specifically, only the Section 1231 gain that survives the lookback loss for

classification will be moved to the 0/15/20% column.

So here we input the $150 Section 1231 lookback loss in the 1231 column.

Again, this is a reclassification, it's not an actual loss.

It reclassifies a part of the net Section 1231 gain as an ordinary gain,

so that less is available to be moved to the 0/15/20% column.

In other words, we're just moving the $150 to the Ordinary Income column.

So now, Carla only has $1,050 left in the net Section 1231 column that

survived the lookback loss.

It is only this remaining amount that's eligible for

the 0/15/20% long-term capital gain treatment.

So in our third step, as we net across columns, we take this $1,050 and

move it to the 0/15/20% column.

We add it to the $6,000 gain from the stock sale,

to give us $7,050 in the 0/15/20% net Long-Term Capital Gain column.

Now we have nothing left in our 1231 column.

$150 was moved to the Ordinary column,

while the $1,050 was moved to the 0/15/20% column.

As we move left to right, next we'll deal with the Short-Term Capital column.

Again, here we have a $7,000 short-term capital loss.

Because this column reports a loss, and

the long-term column reports a gain, we can net the two columns together.

So as we move the $7,000 net short-term capital loss to the 0/15/20%

Long-Term Capital Gain column, and net it with the $7,050 gain,

we're left with $50 of net 0/15/20% long-term capital gains.

Again, this $50 is taxed specifically at 15% because

Carla's ordinary income tax rate bracket is 33%, or

not one of the bottom two brackets, or the very top tax bracket.

Furthermore, the $150 reclassified gain is taxed at

ordinary rates, or Carla's 33% ordinary tax rate.

A final point here.

Notice that in total, Carla is still reporting $200 in gains, exactly as

what we had in our previous example where there were no lookback losses.

All the lookback loss did was shift or reclassify $150 of

the Section 1231 gains out of what would have been eligible for

the 0/15/20% column, and moved it into the Ordinary Income column.

So importantly, the lookback loss does not represent a real loss, so

we do not net it against the gains per se.

The presence of these losses signals that we should only reclassify

the current year net 1231 gain as ordinary income.

In summary, this video introduced Section 1231 assets, and

how they're netted with the other categories of gains and losses.

Section 1231 assets include any real property or depreciable personal

property that's used in a trade or business, or for the production of income.

Importantly, these assets must be held long-term to be

classified as Section 1231 assets.

The tax treatment for these assets is very advantageous.

On the gain side, Section 1231 assets receive preferential

long-term capital gains treatment, taxed at 0, 15, or 20%.

And on the loss side,

Section 1231 assets allow the deduction of losses in full against ordinary income.

There is a small wrinkle in this advantageous tax treatment.

In that if the company claimed any Section 1231 losses in any of the last five years,

then the current year net 1231 gains up to these lookback losses will

be reclassified as ordinary income.

And will not otherwise be eligible for preferential tax rate treatment at 0,

15 or 20%.

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However if the net 1231 gain is larger than any remaining 1231 lookback losses,

or if the lookback losses do not exist, then the net Section 1231

gains are indeed subject to the 0/15/20% preferential tax rates.