A candidate meticulously tracks their client's stock sales. A $10,000 short-term gain, a $5,000 long-term loss. Easy, they think. They net the two for a $5,000 short-term gain. But they missed a crucial detail: the client also sold an old rental property at a gain, creating unrecaptured §1250 gain. By lumping it all together, they miscalculated the tax by hundreds of dollars—a subtle error that costs precious points on the EA exam. This isn't a test of simple math; it's a test of precise ordering and characterization.
For the EA exam, Capital Gains and Losses involve correctly identifying capital assets, determining the holding period (short-term vs. long-term), applying specific tax rates, and executing a strict multi-step netting process. Success hinges on mastering the characterization of gains and losses before any calculation, especially with §1231 property and related-party transactions.
Key facts
- Governing Code: IRC §1221 (Capital Asset), §1222 (Netting), §1231 (Business Property), §267 (Related Parties)
- Individual Deduction Limit: $3,000 per year against ordinary income ($1,500 if married filing separately)
- Holding Periods: Short-term (held one year or less), Long-term (held more than one year)
- Key Forms: Form 8949 (Sales and Other Dispositions of Capital Assets), Schedule D (Capital Gains and Losses)
- Exam Section: Special Enrollment Examination (SEE) Part 1: Individuals
- Official Body: Internal Revenue Service (IRS)
The average pass rate for each part of the Special Enrollment Examination (SEE) is typically between 60% and 70%, according to data published by the IRS (IRS.gov). A solid grasp of core topics like this is essential to land on the passing side of that number.
What are Capital Gains and Losses and Why They Matter on the EA Exam
Capital gains and losses are generated from the sale or exchange of a capital asset, which IRC §1221 defines broadly as almost everything you own for personal or investment purposes. This includes stocks, bonds, your home, and collectibles. It specifically excludes things like inventory, accounts receivable, and depreciable property used in a trade or business (which gets its own special treatment under §1231).
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On the SEE Part 1 exam, this topic is more than just a math problem. The IRS is testing your ability to apply a sequence of rules correctly. They want to know if you can identify a capital asset, determine the correct holding period, characterize the gain or loss properly, and then apply the precise netting rules. Questions are often presented as short scenarios that require you to sift through details and identify the relevant facts.
The most common mistake candidates make is oversimplifying the process. They see a gain and a loss and immediately net them. But the exam creates traps around the character of those items. Is it a loss from a sale to a brother? Is it a gain on a rental property held for 10 years? Each of these details changes the outcome. Your job is to think like a practitioner, spotting these issues before you ever touch a calculator.
Key Concepts and Rules You Must Know
Your success on this topic depends on a solid understanding of four critical areas. We'll break them down here, focusing on how the exam tests your judgment. If you feel shaky on these, our adaptive practice engine at VoraPrep has over 3,000 questions that can help you target these weak spots. Try VoraPrep's free EA practice questions to see how you stack up.
The Capital Gains Netting Process
This is the mechanical core of the topic, and you must have it down cold. It is a precise, multi-step procedure.
Step 1: Separate by Holding Period
First, separate all gains and losses into two piles: short-term (held one year or less) and long-term (held more than one year).Step 2: Net Within Each Pile
Calculate the net short-term capital gain or loss (NSTCG or NSTCL). Then, calculate the net long-term capital gain or loss (NLTCG or NLTCL).Step 3: Net the Results
Now, you can net the results from Step 2.- If you have a gain in one pile and a loss in the other, net them against each other.
- If both are gains or both are losses, you don't net them further at this stage.
Step 4: Apply the Rules
The final character of your gain or loss determines how it's taxed.- A net short-term capital gain is taxed at ordinary income rates.
- A net long-term capital gain is taxed at preferential rates (0%, 15%, or 20%).
- If you have a net capital loss, you can deduct up to $3,000 ($1,500 for MFS) against other income. Any excess is carried forward indefinitely.
Unrecaptured Section 1250 Gain
This is a major tripwire. When a taxpayer sells depreciable real property (like an office building or rental home) held for more than a year at a gain, part of that gain might be "unrecaptured §1250 gain." This is the portion of the gain attributable to straight-line depreciation taken on the property.
> ⚠️ Exam trap: This gain is technically a long-term capital gain, but it is not eligible for the preferential 0%/15%/20% rates. It is taxed at a maximum rate of 25%. Exam questions will test if you correctly pull this amount out of the general LTCG bucket and tax it separately.
Related-Party Transactions (IRC §267)
The IRS is suspicious of transactions between related parties because they can be used to artificially create tax losses. IRC §267 lays out strict rules to prevent this.
Related parties include:
- Family members (spouse, siblings, ancestors, lineal descendants)
- An individual and a corporation where the individual owns more than 50% of the stock
- Other specific relationships outlined in the code.
The rule is simple: Losses on sales of property between related parties are disallowed. The gain, however, is always recognized.
There's a special subsequent sale rule. If the related buyer later sells the property at a gain, they can reduce their recognized gain by the amount of the seller's previously disallowed loss.
Section 1031 Like-Kind Exchange
IRC §1031 allows for the deferral of gain or loss on the exchange of real property held for productive use in a trade or business or for investment. Personal property is no longer eligible.
To qualify, you must exchange one piece of real property for another "like-kind" real property. The key is that the gain is deferred, not eliminated. It is pushed into the basis of the new property. If cash or other non-like-kind property (called "boot") is received in the exchange, the gain is recognized to the extent of the boot. Losses are never recognized in a §1031 exchange, even if boot is received.
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| Feature | §1231 Business Property | §267 Related-Party Sale | §1031 Like-Kind Exchange |
|---|---|---|---|
| Asset Type | Depreciable property used in a trade or business held > 1 year. | Any property. | Real property held for business or investment. |
| Gain Treatment | Long-term capital gain (subject to look-back rule). | Gain is recognized by the seller. | Gain is deferred (unless boot is received). |
| Loss Treatment | Ordinary loss. | Loss is disallowed for the seller. | Loss is never recognized; it's deferred. |
| Exam Focus | Dual nature (ordinary loss vs. capital gain) and 5-year look-back. | Identifying related parties and disallowing the loss. | Calculating deferred gain and basis in new property. |
Worked Example: Putting It All Together
Let's walk through a scenario that mirrors the complexity of a real EA exam question. This isn't about memorizing a formula; it's about applying judgment in the correct order.
> 💡 Worked example: > In 2026, Maria, a single taxpayer, has the following transactions: > 1. Sells 100 shares of XYZ Corp. stock for $25,000. She purchased them 10 months ago for $15,000. > 2. Sells an antique vase for $8,000. Her basis was $12,000. She held it for 3 years as an investment. > 3. Sells a small rental duplex for $300,000. She bought it 5 years ago for $200,000 and has taken $40,000 of straight-line depreciation. Maria has no prior nonrecaptured §1231 losses. > > What is the net effect on Maria's taxable income?
This question layers multiple concepts: a short-term transaction, a long-term collectible loss, and a §1231 gain with unrecaptured §1250 depreciation.
Step 1: Characterize Each Transaction
Before you do any math, classify everything.- XYZ Stock: Held for 10 months. This is a $10,000 Short-Term Capital Gain (STCG). ($25,000 - $15,000).
- Antique Vase: This is a collectible. The $4,000 loss is a Long-Term Capital Loss (LTCL) from a collectible. ($8,000 - $12,000).
- Rental Duplex: This is §1231 property. The total gain is $140,000 ($300,000 amount realized - $160,000 adjusted basis). The adjusted basis is $200,000 cost - $40,000 depreciation.
- Of this gain, $40,000 is Unrecaptured §1250 Gain, taxed at 25%.
- The remaining $100,000 is a §1231 gain, which is treated as a Long-Term Capital Gain (LTCG).
Step 2: Perform the Netting Process
Now, and only now, do we apply the netting rules.- Net Short-Term: Maria has one short-term item: a $10,000 STCG. So, her Net Short-Term Capital Gain (NSTCG) is $10,000.
- Net Long-Term: Maria has three long-term items to consider: the $100,000 §1231 LTCG, the $40,000 unrecaptured §1250 gain, and the $4,000 collectible loss.
- The $4,000 collectible loss first nets against the highest-taxed LTCG. In this case, we have the 25% rate gain. But the rules are complex; generally, you net within rate groups. For exam purposes, the key is to net the LTCL against the LTCG.
- Net LTCG = $100,000 (§1231 gain) + $40,000 (§1250 gain) - $4,000 (collectible loss) = $136,000 Net Long-Term Capital Gain (NLTCG).
- Net the Totals: We have a $10,000 NSTCG and a $136,000 NLTCG. Since both are gains, they don't net against each other. They retain their character.
Step 3: Determine the Tax Impact
- $10,000 NSTCG: Taxed at Maria's ordinary income rate.
- $136,000 NLTCG: This is where the characterization matters.
- $40,000 is Unrecaptured §1250 Gain, taxed at a maximum of 25%.
- The remaining $96,000 is regular LTCG, taxed at preferential rates (0%/15%/20%).
Practice Questions: Test Yourself on Capital Gains and Losses
Theory is one thing; applying it under exam pressure is another. Here are a few questions modeled after what you'll see on the SEE Part 1. Notice how each one tests a specific rule we've discussed.
Sample Question 1: John sells stock with a basis of $30,000 to his brother, David, for $20,000. David holds the stock for two years and sells it to an unrelated party for $35,000. What is David's recognized gain? A) $5,000 B) $15,000 C) $10,000 D) $0> Explanation: The correct answer is A. This is a classic test of the IRC §267 related-party rules. John's initial $10,000 loss ($20,000 sale - $30,000 basis) is disallowed because he sold it to his brother. When David sells the stock, his gain is $15,000 ($35,000 sale - $20,000 basis). However, David can reduce his recognized gain by the amount of John's disallowed loss. Therefore, David's recognized gain is $15,000 - $10,000 = $5,000.
Sample Question 2: In 2026, David sold two blocks of stock. He sold Stock A for $15,000, which he had purchased for $10,000 on January 10, 2025. He sold Stock B for $8,000, which he had purchased for $12,000 on March 15, 2026. What is David’s net capital gain or loss for 2026? A) $1,000 net long-term capital gain B) $1,000 net short-term capital gain C) $5,000 net long-term capital gain D) $4,000 net short-term capital loss> Explanation: The correct answer is A. First, characterize each transaction. Stock A was held for more than a year, resulting in a $5,000 long-term capital gain ($15,000 - $10,000). Stock B was held for less than a year, resulting in a $4,000 short-term capital loss ($8,000 - $12,000). The next step is to net these amounts: $5,000 LTCG - $4,000 STCL = $1,000 net long-term capital gain.
Sample Question 3: Maria, a real estate investor, wants to exchange a rental property she owns for another rental property to improve her portfolio. Both properties are in the United States. Which code section governs this type of transaction to potentially defer gain recognition? A) IRC §1031 B) IRC §121 C) IRC §1231 D) IRC §267> Explanation: The correct answer is A. IRC §1031 specifically governs like-kind exchanges of real property held for productive use in a trade or business or for investment. IRC §121 relates to the exclusion of gain from the sale of a principal residence. IRC §1231 deals with the characterization of gains and losses from business property, and IRC §267 deals with related-party transactions.
Feeling the pressure? That's normal. The key is consistent, targeted practice. VoraPrep's adaptive engine identifies where you're struggling and serves you more questions on those topics until you achieve mastery. Check out our full exam details and format breakdown.
Study Tips and Exam-Day Strategy
- Connect to Basis: Your ability to calculate capital gains and losses is only as good as your ability to calculate basis. Spend time reviewing how basis is determined for purchased property, inherited property, and gifted property. This is a common area for multi-step questions. You can find more on this in our guide to EA Individual Taxation: Tax computation and rates — Complete Study Guide.
- Drill the Netting Process: Write out the netting steps on a flashcard. Practice with different combinations of gains and losses until you can do it without thinking. This should be muscle memory on exam day.
- Focus on Exceptions: The EA exam loves to test the exceptions, not the simple rules. Pay extra attention to the §1231 five-year look-back rule, the disallowed losses for related parties, and the special tax rates for collectibles and unrecaptured §1250 gain.
- Final Week Review: In the last week, don't learn new material. Instead, review your notes and drill practice questions on your weakest areas. Re-read the rules for holding periods, the $3,000 loss limitation, and the related-party definitions.