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Let's say I have a net $100 in Short Term Capital Losses and no Long Term Capital Gains to offset. Let's say I also have $100 in Municipal Bond Interest Earnings, $100 in Qualified Dividends, and $100 in Ordinary Income from a job.

What do the $100 Short Term Capital Losses offset? I'm asking because this makes a huge difference on the final tax bill. Ordinary Income is taxed at a higher rate than Qualified Dividends, and Municipal Bond Interest Earnings are not taxed at all.

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TLDR: net capital loss up to $3k, like all deductions, mostly reduces tax at the ordinary-income marginal rates, but not completely

To get the correct result, you have to actually go through the complete process, because trying to compute each piece separately first and then add them won't work reliably. First off, I'll assume you are single (or possibly head of household), because for married-joint you can only compute the result for the couple not for either spouse alone, and for married-separate a lot of changes or limitations apply.

Also, your example doesn't work, because with only $100 AGI and over $12k standard deduction for single, you have zero tax and it can't be reduced. (Well, except by getting a refundable credit.) But let's consider the more general case:

  • you first add all the items of your gross income together, and subtract the deductions to give taxable income. Some income items (qualified dividends and net long-term capital gains) will later become preferred-rate and the others ordinary-rate, so we can consider G(gross) = O + P although this isn't shown on the return, and then T(taxable) = G - D = O + P - D.

    (Nit: you can elect to change some of your preferred-rate income back to ordinary-rate to get the investment interest deduction on form 4952. For here I ignore that possibility.)

    Muni bond interest isn't included in 'gross' income in the first place, so it isn't there to be deducted from. It is reported on your return on line 2a, but it doesn't affect any of the computations or resulting tax. With one exception: some bonds that are normally tax-exempt are categorized as 'private activity' bonds and if you are subject to the AMT (Alternative Minimum Tax) (which after TCJA'17 fewer people are), private activity bond interest is taxable after all. Check your 1099-INT's for box 9.

  • if there is preferred-rate income (P) as in your case, NOW you subtract T-P and if the result is positive that amount is taxed using the ordinary-rate brackets and rates. After that P is taxed using the preferred-rates brackets and rates, but starting in the bracket where the ordinary-taxed amount (T-P) ended; if T-P is zero or negative there is no ordinary-rate tax and the preferred-rate amount is reduced by any 'leftover' deductions and then starts in the first bracket.

Because T-P = (O+P-D)-P = O-D, your deductions are effectively taken from the ordinary-rate income first. But the preferred-rate bracketing is affected by this remainder (T-P), so the preferred-rate tax will often be higher than it would have been if you had not had the ordinary-rate income.

In short, the only way to get the correct answer for your case(s) is to go through the actual computation for your case(s). It's easy enough with a spreadsheet, and that's what I do.

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  • Thanks for the detailed answer. My personal situation is very similar to most. I'm single, well into the 24% tax bracket, and most of my income is W-2 income. If I understood your answer correctly, in my particular case, my net capital losses will offset my W-2 income. I just wanted to confirm what the spirit of the tax law was, and I think it can be boiled down to: net capital losses tend to offset income with higher tax rates before income with lower tax rates. Is that correct? – AxiomaticNexus Jul 15 at 14:32

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