A capital gain is a profit made from the sale of a capital asset. The sales price exceeds the cost of the investment, referred to as the cost basis. You've incurred a deductible capital loss when you've lost money on an investment.
You'd have a capital gain of $3,000 if you sold an asset for $6,000 and your cost basis was $3,000. You'd have a $3,000 capital loss if you sold the asset for $3,000 but your cost basis was $6,000. The equation is basically sales price less basis.
What Is a Capital Asset?
Capital assets are investments such as stocks, mutual funds, bonds, real estate, precious metals, coins, fine art, and other collectibles. You're taxed on the change in value if your investment has an increase in value when a capital asset is sold.
What Is Cost Basis?
Cost basis is the original price you pay for a capital asset, plus any associated costs, such as commissions paid to brokers. An asset's cost basis must be adjusted up or down to reflect its true cost for tax purposes in some cases. This is referred to as an "adjusted basis," and it's calculated by beginning with the original cost basis, then making adjustments that either increase or decrease that basis.
Tax Treatment of Capital Losses
Losses realized on the purchase and sale of personal property aren't deductible. You can claim up to $3,000 in capital losses as a tax deduction as of the 2020 tax year, however—the return you'd file in 2021. You can carry any unused balance forward to subsequent tax years if your losses exceed this amount. This is subject to a host of rules, however.
You could claim $3,000 a year for three years in many cases if you lost $9,000 overall.
Short-Term vs. Long-Term Gains
Capital gains are taxed depending on what kind of capital asset you've invested in and how long you held that asset. Gains are grouped into short-term and long-term holding periods for tax purposes. The short-term holding period is one year or less. The long-term holding period is more than one year.
Short-term gains are taxed at ordinary income tax rates according to your tax bracket. Long-term capital gains are taxed at their own long-term capital gains rates, which are less than most ordinary tax rates. The long-term capital gains tax rate is either 0%, 15%, or 20% as of 2020, depending on your overall taxable income.
It can be worth it to consider waiting until you've owned an asset for one year and one day if you're on the cusp of selling an asset that will likely result in a profit.
Tax planning for investors focuses on deferring the sale of profitable investments until you qualify for the discounted long-term capital gains tax rate.
Long-Term Capital Gains Tax Rates
Long-term capital gains tax rates are somewhat different from what they were in the past due to provisions of the Tax Cuts and Jobs Act (TCJA) of 2017. These rates were once tied to ordinary income tax brackets.
Long-term, capital gains tax brackets as of 2020 are as follows:
|Tax Rate:||Single Taxpayers||Married Filing Jointly||Heads of Household|
|0%||$0 - $40,000||$0 - $80,000||$0 - $53,600|
|15%||$40,001 - $441,450||$80,001 - $496,600||$53,601 - $469,050|
|20%||$441,451 or more||$496,601 or more||$469,051 or more|
Short-term gains tax rates have changed somewhat as well under the TCJA because the law alters ordinary income tax brackets. The income spans attributable to these brackets are adjusted for inflation as well.
Talk to a tax professional if you realize a capital gain during the tax year. You might be required to make estimated tax payments on that amount to avoid a tax penalty.
Tax Treatment of Other Investments
Short-term gains on collectibles, assets that subject to appreciation recapture, and qualified small business stock are also taxed at ordinary income tax rates, but long-term gains on these assets are taxed at their own rates:
- Collectibles: 28%
- Depreciation recapture: 25%
- Qualified small business stock: 28%
Long-term investments in collectibles are taxed at a flat 28%. Collectibles include:
- Precious metals
- Precious gems
- Rare rugs
- Alcoholic beverages
- Fine art
Some precious metal coins and bullion are considered regular investment assets. They're not collectibles for tax purposes.
Real Property That's Been Depreciated
Real property that has been depreciated is subject to a special depreciation recapture tax. A 25% tax rate applies to the amount of gain that's related to depreciation deductions that were claimed or could have been claimed on a property. The remainder of the gain is taxed at ordinary tax rates or at long-term capital gain tax rates, depending on how long the property was held.
Gains and Losses on Small Business Stock
Capital gains and losses on small business stock might qualify for preferential tax treatment. This tax break applies to small businesses organized as C-corporations.
Gains can be partially or fully excluded from tax under Internal Revenue Code section 1202 if the company had total assets of $50 million or less when the stock was issued. Losses on small C-corporation stock can be treated as ordinary losses up to $50,000 per year under Section 1244 if the company had total paid-in capital of $1 million or less.
Small business investors can request that companies certify their stock as qualifying under Section 1202, Section 1244, or both at the time they make an investment in the company.
Fixed Assets in a Business
Fixed assets used in your business are taxed as ordinary gains. Business assets include all furniture, equipment, and machinery used in a business venture. Examples include computers, desks, chairs, and photocopiers. Ordinary gains are reported on IRS Form 4797.
A Capital Gains Exclusion
An important distinction exists between real estate that's held as an investment and real estate that serves as a taxpayer's primary residence. In the case of personal residences, $250,000 in profit is excluded from capital gains tax for individual taxpayers, and this increases to $500,000 for taxpayers who are married and file joint returns.
The taxpayer must have lived in the home for at least two of the last five years preceding the sale to qualify for the home sale exclusion, and other rules apply as well.
Keep Investment Records
Investors should keep careful track of their investments. This information is essential for calculating the amount of a capital gain. You must know how much you invested, your brokerage fees and commissions, and when you bought the investment. You must also know the date of sale for your investment, the gross proceeds from the sale, and any fees or commissions you paid in the sale.
You might want to use a spreadsheet or personal finance software to keep track of this information. Personal finance programs can provide more robust investment tracking features than spreadsheets. Your broker might also have tools for tracking cost basis, gains, and losses.
Retain any reports and trade confirmations as backup documentation. Annual reports from your broker are especially helpful, and these should be kept along with your other tax-related documents. Trade confirmations and gain/loss reports will come in handy when you're preparing your tax return.
NOTE: Tax laws change periodically. You should always consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice and is not a substitute for tax advice.