Summary

PolicyEngine incorrectly applies Vermont's 40% capital gains exclusion to gains from stocks, bonds, and other financial instruments. Vermont law explicitly excludes these asset types from eligibility for the percentage exclusion. Only the flat $5,000 exclusion applies to gains from financial instruments.

Root Cause

Vermont Schedule IN-153 provides two capital gains exclusion options:

1. Flat Exclusion: $5,000 (available for all capital gains)
2. Percentage Exclusion: Up to 40% of net adjusted capital gain from eligible assets held more than 3 years (capped at $350,000)

The 40% exclusion explicitly excludes gains from:

• Stocks and bonds publicly traded or traded on an exchange
• Any other financial instruments
• Depreciable personal property (other than farm property and standing timber)
• Real estate used as primary or non-primary residence

PolicyEngine appears to apply the 40% exclusion to all long-term capital gains regardless of asset type, resulting in dramatically understated Vermont AGI and tax liability.

Legal Reference

Vermont Schedule IN-153 (Capital Gain Exclusion Calculation):

• Line 13 instructions specify eligible assets for the 40% exclusion
• Vermont Tax Department regulation 10-060-041-X defines capital gains exclusion eligibility

From Vermont Department of Taxes:

"The 40 percent exclusion applies to adjusted net capital gain income from the sale of assets held by the taxpayer for more than 3 years, except from the sale of... stocks and bonds publicly traded or traded on an exchange or any other financial instruments."

Example (from policyengine-taxsim issue #635)

Input:

• Filing status: Head of Household
• Tax year: 2024
• Wage income: $2,576
• Interest income: $344
• Long-term capital gains: $137,498 (from financial instruments)
• Dependents: 1

PolicyEngine calculates:

• Vermont AGI: $93,011 (incorrectly excluding ~$47,000 of capital gains)
• Vermont taxable income: $71,711
• Vermont tax: $2,646

TAXSIM/TaxAct (correct) calculates:

• Vermont AGI: $145,148 (only $5,000 flat exclusion applies)
• Vermont tax: Higher due to correct AGI

The difference is approximately $52,000 in AGI because PolicyEngine applied the 40% exclusion to financial instrument gains that are explicitly ineligible.

Suggested Fix

When calculating the Vermont capital gains exclusion:

1. Create a variable for "VT eligible capital gains" that excludes gains from stocks, bonds, and financial instruments
2. Since TAXSIM/PolicyEngine cannot distinguish asset types in the input, conservatively assume all short_term_capital_gains and long_term_capital_gains are from ineligible assets (financial instruments)
3. Only apply the flat $5,000 exclusion to these gains
4. The 40% exclusion should only apply when asset type is explicitly known to be eligible

Integration Test

- name: VT capital gains exclusion - financial instruments get flat exclusion only
  period: 2024
  absolute_error_margin: 10
  input:
    people:
      person1:
        age: 40
        employment_income: 2576
        taxable_interest_income: 344
        long_term_capital_gains: 137498
        is_tax_unit_head: true
      dependent1:
        age: 10
        is_tax_unit_dependent: true
    tax_units:
      tax_unit:
        members: [person1, dependent1]
    spm_units:
      spm_unit:
        members: [person1, dependent1]
    households:
      household:
        members: [person1, dependent1]
        state_fips: 50  # Vermont
  output:
    # Only $5,000 flat exclusion applies since gains are from financial instruments
    vt_agi: 135418  # Federal AGI minus $5,000 flat exclusion

Related Issues

• VT HoH 2024 137Kltcg 2Kpwages policyengine-taxsim#635