Capital Gains Tax

Essential Tax Tips for Capital Gains and Losses

Snap shot of Form 8949 and Schedule D.
© Diane Macdonald / Moment Open / Getty Images

A capital gain is a profit made from the sale of any capital asset where the sale price exceeds the purchase price of the investment (called the investment's cost basis). If you lost money on an investment, then you incurred a capital loss.

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.

When the capital asset is sold, if your investment has an increase or decrease of value, you are taxed on the change of value of that asset. Investments may also produce income in the form of interest, dividends, rents, and royalties. Income produced by investments is taxed as the income is generated.

What is Cost Basis?

Cost basis is the original price a person paid for a capital asset. Cost basis includes the purchase price and any associated purchase costs (such as commissions paid to brokers).

In some cases, an asset's cost basis needs to be adjusted up or down to reflect its true cost for tax purposes. Adjusted basis is calculated by beginning with an asset's original cost basis, and then making adjustments that either increase or decrease basis.

For example, Steven and Mary bought a house in 1986 for $100,000. Over the years, they have replaced the roof, installed new air conditioning, and made several other improvements.

The cost of those improvements increase their basis in the house. For a couple of years, they rented out the house. The depreciation deductions they took for those years decrease their basis.

For in-depth guidance on basis and adjustments to basis, see:

Tax Treatment of Capital Gains

How capital gains are taxed depends on what kind of capital asset you invested in and how long you held the asset.

Types of Capital Assets

There are special tax rates that apply to the sale of collectibles, depreciable real estate, and small business stocks.

Long-term investments in collectibles are taxed at a flat 28%. Short-term investments in collectibles are taxed as short-term capital gains at your ordinary income tax rates. Collectibles include the following items:

  • stamps,
  • coins,
  • precious metals,
  • precious gems,
  • rare rugs,
  • antiques,
  • alcoholic beverages, and
  • fine art.

Some precious metal coins and bullion, however, are considered regular investment assets and are not considered collectibles for tax purposes under Internal Revenue Code Section 408(m)(3). See also, Publication 17, Your Federal Income Tax, chapter 16.

Real property that has been depreciated is subject to a special depreciation recapture tax. A special 25% tax rate applies to the amount of gain that is related to depreciation deductions that were claimed or could have been claimed on a property.

The remainder of the gain will be taxed at ordinary tax rates or long-term gain tax rates, depending on how long the property was held. For more details on depreciation recapture, refer to Publication 544, Sales and Other Dispositions of Assets, chapter 3, section on Depreciation Recapture.

Capital gains and losses on small business stock may qualify for preferential tax treatment. Specially, this tax break applies to small businesses organized as C-corporations. Gains may 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 may 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. For more details on these two provisions for small business stock, refer to Publication 550, Investment Income and Expenses, chapter 4, especially the section on Gains on Qualified Small Business Stock.

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. Refer to Publication 544, Sales and Other Dispositions of Assets for further details about selling business assets.

Capital Gains Holding Periods: Long Term & Short Term

The holding period measures how long a person has owned an asset.

The holding period begins the day after a person buys an investment until the date the person sells the investment. The IRS states, "To determine how long you held the investment property, begin counting on the date after the day you acquired the property. The day you disposed of the property is part of your holding period." (Publication 550; also refer to Revenue Ruling 70-598.)

For tax purposes, we group capital gains into short-term and long-term holding periods.

The short-term holding period is one year or less. Short-term capital gains are taxed at ordinary income tax rates, which range from 10% to 39.6% for the year 2016.

The long-term holding period is more than one year. Long-term capital gains are taxed at long-term capital gains rates, which are usually less than ordinary tax rates. The long-term capital gains tax rate is either zero percent, 15%, or 20%, depending on your marginal tax bracket.

  • 0% applies to long-term gains and dividend income if a person is in the 10% and 15% tax brackets,
  • 15% applies to long-term gains and dividend income if a person is in the 25%, 28%, 33%, or 35% tax brackets, and
  • 20% applies to long-term gains and dividend income if a person is in the 39.6% tax bracket.

Capital Gains Tax Rates

If your tax bracket is:Then short-term gains are taxed at:And long-term gains are taxed at:
10%10%0%
15%15%0%
25%25%15%
28%28%15%
33%33%15%
35%35%15%
39.6%39.6%20%
Except for the following types of assets:
CollectiblesOrdinary tax rates28%
Depreciation recaptureOrdinary tax rates25%
Qualified small business stockOrdinary tax rates28% after exclusion

 

In addition, high income taxpayers may have a 3.8% unearned income Medicare contribution tax applied to their capital gains and other net investment income. Thus the highest tax rate that could apply to capital gains income is 39.6 + 3.8 = 43.4% on short term gains taxed at ordinary rates or 23.8% (20% + 3.8%) on long-term gains.

Tax planning for investors focuses on deferring the sale of profitable investments until you qualify for the discounted long-term capital gains tax rate.

Keeping Investment Records

Investors need to keep track of all their investments. This information is essential for calculating the amount of capital gain you have. You must know what you bought, how much you invested, your brokerage fees and commissions, and when you bought the investment. You must also know date of sale for your investment, the gross proceeds from the sale, and any fees or commissions you paid to sell.

You may 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 a spreadsheet. Your broker might also have tools for tracking cost basis, gains and losses. There are also specialized investment recordkeeping software, such as GainsKeeper.

You should also 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 preparing your tax return.

Federal Tax Forms Relating to Capital Gains

Capital gains are reported using Schedule D and Form 8949. Taxpayers may need to use the Qualified Dividends and Capital Gain Tax Worksheet, found on page 44 of the Instructions for Form 1040, when calculating the proper amount of federal income tax.

All the details regarding individual trades are reported on Form 8949, and totals from Form 8949 are then summarized on Schedule D, and then transferred to Form 1040. Form 8949 is organized much like a spreadsheet, with all the essential information about each investment you sold during the year. Capital gain or loss is reported for each transaction. Then your total gains or losses are figured. You will have either a net profit or a net loss from all your trades. There are special rules for capital losses, such as annual limitations on capital losses and Wash Sale Rules.

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