AZ income tax incorrectly allows unlimited capital losses to offset income

[MaxGhenis]

Summary

Arizona income tax calculation allows unlimited capital losses to offset ordinary income, instead of using the federal $3,000 capital loss limit. The taxpayer has short-term capital losses of ~$9.7M and long-term capital gains of ~$4.9M, resulting in a net capital loss of ~$4.8M that should be limited to $3,000 for state tax purposes.

Root Cause

Arizona starts from federal AGI, so the capital loss limitation should already be applied. However, PE is likely using raw capital_gains somewhere in the AZ income calculation that bypasses the federal $3,000 limit.

AZ Form 140 starts from "Federal adjusted gross income" (Line 12), which already has the $3,000 capital loss limitation built in from Schedule D Line 21.

Test Case

• Filing: AZ joint 2024
• 1 dependent child
• Short-term capital gains: -$9,670,468
• Long-term capital gains: +$4,900,962
• Net capital loss: -$4,769,506 (limited to -$3,000 federally)

Expected:

• AZ should use federal AGI with capital loss limited to $3,000
• Capital losses should NOT offset other income beyond $3,000

Actual (PE):

• PE allows the excess losses to be deducted against other income

Files to Review

1. policyengine_us/parameters/gov/states/az/tax/income/ - Check if any income source uses capital_gains instead of loss-limited version
2. policyengine_us/variables/gov/states/az/tax/income/ - Check AGI calculation

Suggested Fix

If AZ is using capital_gains in its income sources:

1. Replace with loss_limited_capital_gains (see issue MS income tax incorrectly allows unlimited capital losses to offset income #6964 for implementation)
2. Or ensure AZ properly flows from federal AGI which already has the limitation

Integration Test

- name: AZ joint with capital losses should use federal $3,000 limit
  absolute_error_margin: 100
  period: 2024
  input:
    people:
      person1:
        age: 40
        short_term_capital_gains: -4835234
        long_term_capital_gains: 2450481
        is_tax_unit_head: true
      person2:
        age: 40
        short_term_capital_gains: -4835234
        long_term_capital_gains: 2450481
        is_tax_unit_spouse: true
      child1:
        age: 10
        is_tax_unit_dependent: true
    tax_units:
      tax_unit:
        members: [person1, person2, child1]
    spm_units:
      spm_unit:
        members: [person1, person2, child1]
    households:
      household:
        members: [person1, person2, child1]
        state_fips: 4  # Arizona
  output:
    az_income_tax: ???  # Need TaxAct comparison

References

• AZ Form 140 Instructions - Starts from Federal AGI
• Federal Schedule D - Line 21 limits capital losses to $3,000

Related Issues

• AZ joint 2024 1depx -9670Kstcg 4900Kltcg policyengine-taxsim#619: AZ joint 2024 1depx -9670Kstcg 4900Kltcg
• MS income tax incorrectly allows unlimited capital losses to offset income #6964: MS income tax incorrectly allows unlimited capital losses to offset income (same root cause)