WHAT ARE CAPITAL GAINS AND HOW ARE THEY TAXED?

Article by: Jeff Skolnick, CPA, M.S. Taxation

There is always a great deal of discussion on capital gains and losses, including special tax rates and short term and long term holding periods.

This article addresses some of the basic questions.

What Transactions Are Considered Capital Transactions?

Gains or losses resulting from the sales of capital assets are capital transactions. The Internal Revenue Code defines a capital asset as any property except:

1. inventory;

2. depreciable or real property used in the taxpayer's trade or business;

3. specified literary or artistic property;

4. business accounts or notes receivable; or

5. certain U.S. publications.

The most common types of capital assets would include stocks, bonds, mutual funds, and land held for investment.

What Are The Current Tax Rates on Capital Gains?

Short term capital gains are taxed at the same rates as ordinary income (somewhere between 10% and 37% depending on your tax bracket).

Long term capital gains also have different rates. The long term capital gains tax rates are 0%,15% or 20% depending on your taxable income and filing status.

There are also long term capital gains taxed at 25%. These occur in certain sales of depreciable real estate.

There is also a 28% tax rate used for collectibles and certain corporate stock sales.

What Is The Difference Between Long Term And Short Term Capital Gains?

Assets held for one year or less are considered short term while assets held for more than one year are considered long term.

Can Capital Losses Be Used To Offset Capital Gains?

Although short term and long term capital gains are taxed at different rates, losses from one category can offset income in the other. For example, if you have a $10,000 short term capital gain and a $5,000 long term loss, then you would be taxed on $5,000 of gain at ordinary income tax rates.

If the situation was reversed (a $10,000 long term gain and a $5,000 short term loss) then you would be taxed on $5,000 at long term capital gain rates.

Keep in mind that although your losses can exceed your gains, you may only deduct $3,000 of losses in excess of gains in any year. If we change the example above to a $10,000 short term capital gain and a $30,000 long term capital loss, then you would offset all of the $10,000 short term gain plus an additional $3,000 with the long term loss. Since your long term loss was $30,000 and only $13,000 was used, then the remaining $17,000 is carried over to the next year’s tax return.

Although capital losses can be carried forward indefinitely, they may never be carried back against prior year capital gains. This can have a profound impact on your return. 

Let’s say that you have a $1,000,000 capital loss one year and a $1,000,000 capital gain the next year. For this example, ignore the rule about allowing $3,000 of capital losses in excess of capital gains as it is immaterial and makes the example a little easier to understand. In the situation I just outlined clearly the $1,000,000 of unused capital loss can be carried forward to offset the capital gain in the next year resulting in $0 of taxable income.

If I change this scenario around and have the $1,000,000 capital gain occur in year one and the $1,000,000 capital loss in year two the result is the $1,000,000 is taxed as a capital gain (long or short term based on the amount of time the item had been owned) in year one and the $1,000,000 loss in year two cannot be used to offset this gain. It can only be used to offset future capital gains plus an additional $3,000 per year. If in year two the taxpayer had a $20,000 capital gain then $23,000 of the loss would be used (enough to offset all of the gain plus an additional $3,000) and $977,000 would be carried forward.

The reason I point this out is it is a rule that I believe to be unfair. In both scenarios, there was a $1,000,000 gain and a $1,000,000 loss which should net to $0. Unfortunately, because of the way the law is written if you incur a gain before a loss you will pay taxes even though economically you were not any better off than if you incurred the loss initially and then the gain.

Net Investment Tax

There is a net investment income tax of 3.8% which is levied on taxpayers with Modified Adjusted Gross Income over $250,000 for married individuals filing jointly, $125,000 for married individuals filing separately and $200,000 for everyone else. This tax is on the lesser of the investment income or the income in excess of the aforementioned limits. Capital gains and losses are considered to be investment income. This tax is in addition to any income tax levied whether at ordinary rates or more preferential long term rates.

Tax planning

As a general rule, I would like tax consequences to be a factor in your investing strategy, but by no means the only factor. For example, if you are thinking of selling a real estate investment property and you are planning to buy another, then, by all means, see if you can take advantage of the tax-free exchange provision or even move in for a few years to then get the sale of home residence exclusion. I also, like many accountants, advise my clients to search for items in their portfolio that may have losses and you no longer like. If you like a stock and it is just down, I don’t advise selling it to take a loss and buying back later. First, if all if you do this too quickly (within 30 days) this is called a wash sale and the loss is disallowed.

Conclusion

This article discusses capital gains and losses. While I have given a quick overview, this area can be quite complex. I would encourage anyone with significant capital transactions to contact a tax professional.

Check out this topic in my latest podcast: Click Here!