After the last major overhaul of the tax code, implemented by President Ronald Reagan in 1986, the words Capital Gains were almost considered dirty.
The term provoked fear, anxiety and warnings that this was a tax best avoided. A capital gain was taxed just like ordinary income such as wages. Presidents immediately following Reagan slowly cut the capital gains tax rate, insisting the tax cuts were needed to stimulate investment spending by the wealthiest citizens.
While many welcomed this change, others felt it was an unfair tax advantage for the rich. This stance was supported by billionaire Warren Buffet, who criticized the tax cuts, citing his personal tax rate of 17% because all his income was investment related. This was a lower rate than his secretary and other employees in his office paid.
While this issue continues to be a political football, many taxpayers aren't familiar with this part of the tax code.
The Least You Need to Know About Capital Gains and Losses
Capital gains and losses result from selling a capital asset (most property you own for either personal use or as an investment) for either a profit or a loss.
These assets can be personal use items like your home, car (if used in business and depreciated) or collectibles or investment property like stocks and bonds. A capital gain is established by comparing the selling price of the property to the cost basis (usually the original cost of the item) or adjusted cost basis (which includes improvements or other expenses for the property).
If the selling price is more than the cost basis, this is a capital gain, while selling for less than the cost basis results in a capital loss.
A capital gain is taxable at a preferred rate depending on other factors, including your income, your filing status, the type of asset and the amount of investment income you have. A capital loss can generally be deductible against your other income provided it is investment income and not personal property, such as your primary residence.
The Long and Short of It
Besides basis, another important piece of information is whether your asset was considered a short-term or long-term asset. This refers to the holding period a taxpayer owns the property.
A short-term gain or loss is the result of holding a property for exactly one year or less when you sell. If it is held for more than one year, then it qualifies as a long-term capital gain or loss. Long-term capital gains are usually taxed at a lower rate.
The Difference Between Capital Gains Tax Rates and Regular Income Tax
Any capital gain you make on a short-term property is taxed at your regular income tax rate. So if your initial investment was $10,000 and you sold the same stock for $12,000 six months later, you would pay tax on the $2,000 as if you had earned it as other taxable income.
However, if you can hold on to a property for more than one year, you could pay significantly less. If you are in the 10% and 15% income tax bracket, you will not have to pay any tax on the sale.
The 25% to 35% brackets will pay 15%. The wealthiest taxpayers in the 39.6% bracket will only pay 20%. This can mean significant savings on the amount of tax you pay and it rewards investors who hold their property for a longer term.
There are a few types of gains that are taxed at a 25% or 28% such as collectibles. Also, keep in mind that there is an additional 3.8% net investment tax when your income is over certain thresholds ($200,000 for Single, $250,000 for Married Filing Jointly and $125,000 for Married Filing Single)
So Can You Deduct a Capital Loss?
You can deduct a capital loss only if the loss is on an investment property. The IRS does not allow you to claim the entire loss against your other income as it does for other losses, such as those incurred from a business or rental property.
In those cases, depending on your income and type of property, you could potentially take the entire loss in one year. A capital loss is limited to a maximum of $3,000 a year ($1,500 if you are Married Filing Separate).
This means that if you have $100,000 of other taxable income such as wages, interest, dividends, etc., you would automatically be at $97,000 before other adjustments to your income.
The good news is that if your loss is more than $3,000, you can carry forward the unused part of your loss from year to year in $3,000 increments until the loss is completely used up.
Make sure your tax advisor is also aware of this part of the tax code. If not, find someone who is.