Domain 3 - Income Taxation
Domain 3 - Income Taxation
This domain tests the individual tax formula, the boundary between exclusions, deductions and credits, capital gains mechanics, and planning that shifts or defers income. Most items are arithmetic with one tax character twist.
The formula
Gross income (§61 - all income unless specifically excluded) → adjustments (HSA, traditional IRA, half of self-employment tax, self-employed health insurance, student loan interest) → AGI → standard or itemized deductions → taxable income → tax → credits → payments. Credits reduce tax dollar for dollar; deductions reduce it by the marginal rate.
Character and rate
- Short-term capital gain (held one year or less) is ordinary income; long-term gain is taxed at 0/15/20% based on where it stacks on top of ordinary income.
- Net capital losses offset gains plus $3,000 of ordinary income per year; excess carries forward.
- Wash sale: a loss is disallowed if substantially identical securities are bought within 30 days before or after.
- 3.8% net investment income tax and the 0.9% additional Medicare tax apply above MAGI thresholds; they are not part of the bracket structure.
- §199A gives a 20% qualified business income deduction, subject to limitations.
Planning levers
Timing (accelerate deductions, defer income), income shifting (gifts, family employment, kiddie tax limits), vehicle choice (deductible traditional versus tax-free Roth), and basis management (§1014 step-up at death; §121 exclusion of $250,000/$500,000 on a principal residence).
Worked example. Single filer, taxable income $120,000, including $20,000 of long-term capital gain. Ordinary taxable income = $100,000. Tax on it = $1,160 + 12% × $35,550 + 22% × $52,850 = $17,053. The gain stacks above $100,000, entirely in the 15% band, so $20,000 × 15% = $3,000. Total tax = $20,053; effective rate = $20,053 ÷ $120,000 = 16.7%, well below the 22% marginal bracket.
Traps. Multiplying total income by the marginal rate; stacking capital gains from the bottom; forgetting the NIIT on top of the bracket rate; assuming itemizing always beats the standard deduction; confusing a deduction with a credit; ignoring state tax when comparing a municipal bond to a taxable bond.