At its most basic, taxation is simply the process of accruing wealth and then paying a percentage of that wealth to the government in exchange for services. However, not all wealth is treated the same when it comes to your income taxes.
While most people have a working knowledge of how their ordinary income is taxed—such as wages from your job—another key form of income which must be accounted for is one’s capital gains.
Generally speaking, capital gains are a bit more complex and slightly less understood by the average taxpayer than their ordinary income. The basic rules are pretty simple, and most people may feel they have a grasp of the concepts, but as we will see one can quickly get mired in complications. The rules for capital gains and losses are a good example of what often occurs in Federal tax law: It is difficult to provide a simple explanation because there are rules, then exceptions to the rules, then exceptions to the exceptions, then variations of all of the foregoing. IRS Publication 544, Sales and Other Dispositions of Property, which deals mostly with the rules governing capital gains and losses, runs for 43 triple-column pages!
Capital gains are the profits you make upon the sale or disposition of some form of property, known as a capital asset. Capital assets include property such as stocks and real estate. So, if you were to purchase a home for $150,000 and sell it for $200,000, your capital gain on the transaction would be $50,000. (At even this early point, I should note that the basis of a capital asset, the amount that offsets the sale proceeds, can be a hugely complicated matter, worthy of a separate blog post. It is not as simple as what you paid for the asset – what if you depreciated it? What if you were entitled to depreciate it but did not? What if you inherited the asset, or received it as a gift, or as compensation for services? What if you are selling less than all of your holdings of a particular stock and there have been stock dividends, stock splits, reverse stock splits, or other adjustments, since you acquired the stock? All of these complications and more can come into account in the “simple” matter of determining the basis of property.)
The most important thing to understand about capital gains is that the profits are only taxed after they are realized. (But remember what I said about exceptions – even a “realized” gain may be deferred and not taxed currently if it is not “recognized” because of a special rule, such as applies to a like-kind exchange of real estate, also known as a “tax-free” or “tax-deferred” “swap.”) What that means is, just because an asset you own is appreciating in value does not mean you are going to have to pay taxes on it—at least not yet. The value of your stock holdings can grow and grow without you having to pay taxes on them until you actually sell the stock and gain the benefits from the increase in value. (But remember what I said about exceptions – for certain kinds of assets, such as publicly-traded stocks, if you are a dealer you may have to report and pay tax on gains under the “mark to market” rules even if you have not sold the stock.) Generally, though, a capital gain is only realized—and taxed—when a capital asset is sold or disposed of.
When the capital gain is realized (and recognized), that is when you will have to pay the capital gains tax on your profits. Fortunately, capital gains are taxed at significantly lower rates than those of ordinary income. In 2016, the lowest income tax bracket—individuals making between $0 and $9,275—will be required to pay a 10% tax on their ordinary income. If those same individuals realize a capital gain, those gains will be taxed at a 0% rate. At the other end of the spectrum, the highest tax bracket for ordinary income must pay 39.6% while those same individuals will generally pay only a 20% tax rate on their capital gains. (But remember what I said about exceptions – certain taxpayers under certain circumstances may pay tax on capital gains at as high as a 28% rate.)
It is important to note that these rates are only applicable for long-term capital gains, or gains on the taxable disposition of capital assets which were held for more than one year before they were sold. If you own a capital asset for no more than one year and you decide to sell it, you will pay the same tax rate on any realized gains as you would on your ordinary income.
For purposes of accounting for and reporting capital gains and losses, it is necessary to account for long-term gains and losses separately from short-term gains and losses, primarily because of the complicated rules dealing with the limitations on deducting capital losses in a taxable year. Net capital losses, that is capital losses in excess of capital gains, whether long-term or short-term, can be deducted up to a limit of $3,000 in any taxable year. (But remember what I said about exceptions – a married taxpayer filing separately has a limit of $1,500.)
Better news – if you have a net long-term gain and a net short-term loss, or vice versa, the loss can be used to offset the gain without limit; the $3,000 (or $1,500) limit applies to any excess loss. If you have both a short-term and a long-term capital loss, the short-term loss is applied first against the $3,000 (or $1,500 limit). Capital losses in excess of these limits are carried over to successive taxable years, without limit. Carried over losses retain their character as short-term or long-term in applying these rules in the successive taxable years. If married taxpayers filed jointly in the loss year and filed separately in the carryover year, or vice versa, the accounting, application, limitation and carryover rules can be monstrously complicated.
If you have questions about capital gains, or you are in need of any other form of tax guidance, please do not hesitate to give me a call today!
Written by E. Morgan Maxwell
Since beginning his own firm, Mr. Maxwell has continued a tax-law oriented practice encompassing a wide range of transactions, planning and dispute resolution. His dispute resolution experience includes involvement at all levels of the Internal Revenue Service (Examinations, Appeals, Collections, Office of Professional Responsibility, the U.S. Tax Court), the Pennsylvania Department of Revenue, the Tax Litigation Section of the Pennsylvania Attorney General’s Office, Pennsylvania Commonwealth Court, Common Pleas Court and local taxing jurisdictions in southeastern Pennsylvania.
