The definition of a capital gain can be defined as making a profit on an asset that was purchased at a lower price than what it was purchased for. Conversely, a capital loss is when that same asset is sold for less than the purchase price. The sales of certain assets are subject to capital gains tax, such as stock and bond investments, property, and even the sale of metals like gold and silver.
Capital gains tax comes into play when the asset is sold for a profit. The sale is thus viewed as a transfer in exchange for money. This is different then a trade or an exchange. A trade is a transfer of an asset, such as property, for other assets, property or services. Ordinarily, a transaction is not a trade when real property or other assets are voluntarily sold for cash and then the purchaser immediately buys similar property to replace it. The sale and purchase are treated as two separate transactions.
How does capital gain tax work? What tax laws does the IRS code set out regarding capital gains tax? What types of investments are subject to capital gains tax? In answering these questions, we will look at some specific information regarding the two largest and most common assets subject to capital gains tax: stocks and property.
Capital gains tax is based on cost basis, and in order to ascertain if one has a sale subject to this tax, cost basis must first be determined. Cost basis is a way of measuring the investment in terms of dollars. For example, the cost basis of a stock sale is determined by a comparison of the purchase price vs. the sale price. The cost basis of property is the amount paid for the property in both cash and debt obligations already on the property, plus any fees involved in acquiring the property, compared to what that same property is sold for.
As an example… If a home was purchased for $164,500, and the purchaser also paid settlement costs of $490 for legal and recording fees, plus $5,600 in real estate taxes, then the starting basis of that asset is $170,590.
Capital Gains vs. Ordinary Gains
If an individual has a taxable gain or a deductible loss from a transaction, it may be either a capital gain or loss or an ordinary gain or loss, depending on the circumstances. Generally, a sale or trade of a capital asset results in a capital gain or loss, and a sale or trade of a non-capital asset generally results in ordinary gain or loss.
A capital asset may be defined as something owned by an individual and used for personal purposes. A non-capital asset is an asset held for sale to customers. For example, stocks held by an investor and then sold are subject to capital gains tax because they are a capital asset. But that same stock held by a dealer for sale to customers is considered inventory, and thus is a non-capital asset, and not subject to capital gains tax.
Depending on the circumstances, a gain or loss on a sale or trade of property used in a trade or business may be treated as either capital or ordinary. In some situations, part of a gain or loss may be a capital gain or a capital loss, and part may be an ordinary gain or an ordinary loss. Generally, taxpayers will have a capital gain or loss after the sale or exchange of a capital asset. They also may have a capital gain if a Section 1231 transaction results in a net gain. Section 1231 transactions are sales and exchanges of property held longer than one year and either used in a trade or business or held for the production of rents or royalties.
The reporting of a capital gain or loss depends on how long the asset is owned before it’s sold or exchanged. The length of time the asset is owned before disposed of is known as the holding period. Assets are acquired and sold based on the transaction date, notthe settlementdate. For example, certain stock purchases and sales often have a delay of several days to settle thepurchase or sale and to transact the fees, therefore the asset may have a different transaction date (the date the asset is bought or sold) than the settlement date (the date the stock is acquired by a purchaser).
Holding periods are classified as either short term or long term. If a capital asset is held for one year or less, the gain or loss from its disposition is considered short term. If the capital asset is held longer than one year, the gain or loss is considered long-term.
The general rule for determining the holding period is to begin counting on the first date after the day the property is acquired. The same date of each successive month is the beginning of a new month, regardless of the number of days in the preceding month. The last day of the holding period is the day of disposition.
For example, stock purchased on May 21st 2007 and sold on May 21st 2008 would be considered short term because the holding period did not begin until May 22nd 2007, the day after it was purchased. So that stock was held for just under one year. If that same stock was purchased on May 21st 2007 and sold on May 23rd 2008, it is a long-term transaction because it was held for a year and a day.
Capital Gains in Stock
The basis of stock is generally the purchase price plus any costs of purchase, such as commissions and recording or transfer fees. The basis also may need to be adjusted because of certain events that occur after the purchase. These unique events may either increase or decrease the original basis.
One such event that adjusts the basis of stock is when the stock splits. In a stock split, the parent corporation issues additional shares of stock to the stockholders, thereby dividing the stockholder interest into a larger number of shares. For example, a basis of $1,000 for 100 shares ($10 per share) would be spread over 200 shares after a two-for-one split, thus reducing the value to $5 a share.
With stock sales, exact cost basis should be kept. Many individuals may want to take an average, especially if they are a trader with many transactions. However, the IRS does not allow this. Also, for recordkeeping purposes, first in-first out is the acceptable sales order unless the broker agrees, in writing, that a particular lot is sold.
Another point to keep in mind when dealing with stock and its potential taxability is that the IRS filing requirement for reporting stock is not based on the ultimate cost basis and whether or not one had a gain or a loss, but rather on the amount of transactions one has. An individual may know that they lost money on their trades, but the IRS does not know this until a return is filed, along with a Schedule D, which demonstrates the cost basis. This is because a brokerage is only required to report the purchase price of the stock, and not the sale price.
The purchase price is reported to the IRS via a 1099-B document, and the taxpayer is also provided a copy. Individuals that fail to file a return to show their cost basis may be subject to an audit assessment, whereby the IRS will simply add up the purchase prices of all the transactions and run a straight tax on the aggregate total.
Capital Gains in Property
When determining the cost basis on the sale of property and whether or not that sale is subject to capital gains tax, there are a number of other items that must be factored in. State and local sales tax must be included unless that amount has been taken as a tax deduction. Any debt obligation or existing mortgage an individual assumes on the property also counts toward the initial cost basis. Real estate taxes imposed on and paid by the seller, unless they are reimbursed, also factor in. Certain settlement and closing costs also come into play, and may or may not be included in the cost, depending on if a tax deduction has already been taken for them in the form of mortgage “points.”
When property is constructed rather than purchased, the costs that are incurred in the construction are part of the basis. The value of an individual’s own labor is not included when determining the basis, even if the individual is professionally engaged in that field.
After establishing a property’s cost basis, certain types of events can change this original basis. These changes either increase or decrease the original basis, resulting in what is called the adjusted basis. Usually, the adjusted basis is the amount that is used to compute gain or loss when the property is sold.
An example of this would be capital improvements. Capital improvementsadd to or restore the value of the property, substantially prolong its useful life, or adapt it to new uses. These items increasethe basis. General repair work thatmaintains the property in its ordinary, efficient operating condition does notincrease the basis.
Some common events that decrease the basis in property are casualty and theft, easements, residential energy credits, and depreciation. Casualty and theft reduces the basis by the amount of the insurance reimbursement and by any additional deductions taken on the tax returns. An easement is the right one gives a person or entity to make limited use of another’s real property. For example, a power company may “purchase” a section of one’s property in order to run power lines. The amount they pay for this use is deducted from the original basis.
An individual involved in the sale or exchange of reportable real estate transactions may receive from the IRS a Form 1099-S, Proceeds from Real EstateTransaction. If an individual sold personal property and had a gain, the gain is considered a capital gain for tax purposes. However, if the personal property was sold at a loss, the loss is generally not tax deductible. Only losses on business or investment property are deductible, with one exception. If inherited property is not used for personal purposes but is put up for sale, any loss will qualify as a deductible loss.
An individual may qualify to exclude any capital gains from the sale of their primary home. This means that capital gains tax does not have to be paid on the net profit from the sale of a home, up to the maximum exclusion limit. The current exclusion limit is $250,000. In order to qualify, a home must meet an ownership test and a use test. These two tests require an individual to own the home and live in the home for two years before the sale can be excluded from capital gains tax. (See the IRS Publication 17, Your Federal Income Tax, Chapters 13 through 16 for detailed information on the sale of property.)
How to Report Capital Gains Tax
Individuals use a Schedule D, Capital Gains and Losses, in association with their Form 1040, to report transactions involving capital assets. In order to complete Schedule D accurately, individuals must first determine whether the holding period is long-term or short-term. Once determined, report the capital asset transactions in Part I (short-term) or Part II (long-term) and make the necessary computations to arrive at the net capital gain or loss, which then gets reported on the 1040. If the net result is a capital loss, apply the rules for capital loss limitation and, possibly, capital loss carryover.
Line 21 of Schedule D currently limits the amount of capital losses that may be deducted in a tax year. The current yearly limitation on capital losses is the lesserof a taxpayer’s actual loss (Schedule D line 16), or $3,000 ($1,500 for married filing separately).
When capital losses exceed the capital loss deduction limitation, the excess can be carried forward to later years to offset capital gains and other income. This carryover continues until the loss is fully absorbed. When carried forward, the loss retains its original character as either short-term or long-term. The carryover amount is shown on lines 6 or 14 of the Schedule D. When figuring the amount of any capital loss carryover to the next year, take the current year’s allowable deduction into account, whether or not it’s been claimed or if a return has been filed for the current year.
The IRS has a worksheet in the Schedule D instruction booklet to help determine the amount of a capital loss carryover.
Useful IRS Tax Resources
www.irs.gov keyword “Capital Gains”
Publication 17, Your Federal Income Tax
Publication 523, Selling Your Home
Publication 550, Investment Income and Expenses
Publication 551, Basis of Assets
Publication 544, Sales and Other Dispositions of Assets
Form 1040, Schedule D Instructions, Capital Gains and Losses