A capital gain or loss results from the sale, trade, or exchange of a capital asset. For tax purposes, capital assets include most personal durable goods, investments, and real estate, including stocks and homes. Simply stated, when a transaction nets an amount higher or lower than the value of the capital asset, as measured by what is known as its "basis," a capital gain or loss occurs, and is distinguished from a so-called ordinary gain or loss. A profit on the sale of a capital good—a capital gain—incurs a tax liability, whereas a loss may provide for a tax deduction. Capital gains and losses can either be short-term (transactions completed within one year) or long-term (transactions completed in more than one year). The factors relevant to compute a capital gain or loss are the kind of capital asset, the kind of transaction, and the duration the asset was held.
The taxation of capital gains causes much debate in government and economic circles. Current U.S. tax policy is based on the presumed benefits and efficiencies of capital accumulation and utilization. To encourage capital formation and investment, the federal government taxes capital gains at lower rates than ordinary income. In 1997 a cut in the U.S. capital gains tax took effect, lowering the rate for most capital gains from 28 percent to 20 percent. This compares with a maximum income tax rate of 39.6 percent for persons earning $278,450 or more per year. Historically, the capital gains tax had stood at 28 percent since 1986. From 1981 to 1986 it rested at 20 percent, and before that it had been 28 percent. During the 1970s it reached as high as 35 percent.
U.S. tax code defines capital assets broadly to include most personal property and investments. They include stocks and bonds, a residence, household furnishings, a personal car, coin and stamp collections, gems and jewelry, and precious metals.
All investment property is a capital asset. Therefore, any gain or loss is generally a capital gain or loss, but only when it is realized, that is, upon completion of the transactional event. For example, the public is familiar with the vagaries of the stock market where investors often claim substantial gain/loss in their positions. For a gain/loss to be realized, investors must actually sell shares at a market price higher or lower than their original purchase price.
The federal revenue code (Section 1244) treats losses on certain small business stock differently. If a loss is realized, one can deduct the loss as an ordinary loss. The individual, however, if holding the stock, will report gains as capital gain.
The sale of a personal residence enjoys special tax treatment in order to minimize the impact of long-term inflation, and to accommodate the changing lifestyle needs of persons 55 and over.
The residence, for most, is the largest asset an individual owns. While some appreciation is expected, residences are not primarily investment vehicles. Inflation may cause the value of a home to increase substantially while the constant-dollar value may increase very little. In addition, the growth in family size may encourage a family to step up to a larger home. To minimize the impact of inflation and to subsidize the new purchase, the tax code does not require reporting a capital gain if the individual purchases a more expensive house within two years.
For individuals 55 and over who are downsizing (perhaps due to the "empty nest"), the code allows a once-in-a-lifetime exclusion of $125,000 of realized gain if the owners lived in that home three years of the last five.
Any capital gain or loss on investment property held for one year or less is a short-term capital gain or loss. Capital gain or loss on property held for more than one year is long-term. The period is determined from the day after acquisition to the day of disposal. This also applies to securities purchased on established markets irrespective of the settlement dates.
Capital gain/loss is calculated on the cost basis which is the amount of cash and debt obligation used to pay for a property, and the fair market value of other property or services the purchaser provided in the transaction. The purchase of a property may include these charges and fees which are added to the basis to arrive at the adjusted basis:
The basis may be increased by the value of capital improvements, assessments for site improvements (such as the public infrastructure), and the restoration of damaged property.
A basis is reduced by transactional events that recoup part of the original purchase price through tax savings, tax credits, and other transactions. These include depreciation, nontaxable corporate distributions, various environmental and energy credits, reimbursed casualty or theft losses, and the sale of an easement.
After adjusting the basis for these various factors, the individual subtracts the adjusted basis from the net proceeds of the sale to determine gain/loss.
To calculate the net gain/loss, the individual first determines the long-term gain/loss and short-term gain/loss separately. The net short-term gain/loss is the difference between short-term gains and short-term losses. Likewise, this difference on a long-term basis is the net long-term gain/loss.
If the individual's total capital gain is more than the total capital loss, the excess is taxable generally at the same rate as the ordinary income. However, the part of the capital gain which is the same amount as the net capital gain is taxed only at the capital gains tax rate, a maximum of 20 percent.
If the individual's capital losses are more than the total capital gains, the excess is deductible up to $3,000 per year from ordinary income. The remaining loss is carried forward and deducted at a rate up to $3,000 until the entire capital loss is written off.
SEE ALSO : Taxes and Taxation
[ Roger J. AbiNader ]
Kadlec, Daniel. "Capital Gain = Market Pain?" Time, 18 August 1997, 44.
U.S. Treasury Department. Internal Revenue Service. Publication 17. Washington, 1998. Available from www.irs.ustreas.gov .
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