Capital gains tax is imposed on gains realized from the sale of capital assets such as a home, investments, and business interests. Under the Jobs and Growth Tax Relief Reconciliation Act of 2003 (2003 Tax Act) and the Tax Increase Prevention and Reconciliation Act of 2005 (2005 Tax Act), certain dividends are also taxed at capital gains tax rates. Generally, capital gains tax rates are lower than the rates applied to ordinary income.
Capital gains tax on sale or exchange of capital assets
If you sell or exchange a capital asset for more than its basis (cost), the profit is a capital gain. If you sell or exchange a capital asset at a loss, you can use the loss to offset capital gains (subject to the netting rules, discussed below). If your capital losses exceed your gains, you can offset a certain amount of ordinary income and/or carry the loss forward into future tax years.
The tax rate that will apply to the sale or exchange of a capital asset depends on a number of factors including the type of asset, how long you owned (held) the asset, and your marginal tax bracket.
For more information on capital assets, see Capital Gain Income and Loss.
Tip: Under the homesale exclusion, gain on the sale of your principal residence (up to certain limits) can be excluded from income, as long as certain conditions are met. For more information, see Exclusion of Capital Gain On the Sale of Your Home.
Holding period refers to the length of time you held a capital asset before selling or exchanging it. A gain is classified as short-term if you held the asset for a year or less before selling it, and long-term if the asset was held for longer than a year. This distinction is important because net short-term capital gains are taxed at ordinary income rates, whereas long-term capital gains are taxed at the more favorable long-term capital gains tax rates. Further, assets held for more than five years may qualify for a special capital gains tax rate.
How do capital gains tax rates differ from ordinary income tax rates?
Capital gain income is generally preferable to ordinary income. Currently, the highest marginal income tax rate is 35 percent, while long-term capital gains tax rates vary from 5 percent to 28 percent, depending on the asset and your marginal tax rate. Generally, current long-term capital gains tax rates can be grouped as follows:
·28 percent for collectibles and small business stock
·25 percent for unrecaptured Section 1250 Gain
·15 percent for sales or exchanges made on or after May 6, 2003 for taxpayers in marginal tax brackets higher than 15 percent (for assets that do not fall within the 28 percent or 25 percent groups)
·0 percent for sales or exchanges made in tax years 2008 through 2010 for taxpayers in marginal tax brackets of 15 percent or 10 percent (for assets that do not fall within the 28 percent or 25 percent groups)
If your capital gain in a given year pushes you into a higher tax bracket, which capital gain rate do you use?
Suppose you are normally in the 15 percent marginal tax bracket, but in December of this year, you sell an asset held for two years and realize a substantial long-term capital gain. Will the full capital gain be untaxed because of the 0 percent rate? Maybe not. If your capital gain pushes you into a higher tax bracket, you can use a preferred capital gains tax rate of 0 percent on a portion of the capital gain only. The remainder of your capital gain will be taxed at the higher 15 percent rate.
Example(s): Assume John is single and he's normally in the 15 percent tax bracket. In fact, his ordinary income this year falls short of the 25 percent tax bracket by $10,000. However, John sells an asset in December of this year and realizes a long-term capital gain of $40,000. The first $10,000 of his capital gain will not be taxed because of the 0 percent rate, and the remaining $30,000 will be taxed at 15 percent.
What are the netting rules?
In order to properly compute your capital gains tax, you should be aware of the manner in which capital gains and losses may offset one another. These rules are known as the "netting rules." Generally speaking, the tax code prescribes that short-term capital gains and losses must be netted against each other first. Next, long-term capital gains and losses are netted against one another according to a set of ordering rules. Finally, net short-term gains or losses must be netted against net long-term gains or losses in a prescribed manner.
The ordering rules apply if you have long-term capital gains that are subject to different rates of tax. With respect to long-term capital gains and losses, the following rules apply:
·Long-term gains and losses are first grouped by tax rate (28 percent group, 25 percent group, and (for taxpayers in marginal brackets over 15 percent) 15 percent group).
·Losses for each long-term tax rate group are used to offset gains within the group, resulting in a net long-term gain or loss for each group.
·If a net short-term capital loss exists, it reduces net long-term gain from the 28 percent group first, then from the 25 percent group, and finally from the15 percent group.
·A net loss from the 28 percent group is used first to reduce gain from the 25 percent group, then to reduce net gain from the 15 percent group. And a net loss from the 15 percent group is used first to reduce net gain from the 28 percent group and then to reduce gain from the 25 percent group.
·Any remaining net capital gain in a particular rate group is taxed at that group's marginal rate.
Example(s): Assume Hal is in the top marginal tax bracket and has a short-term capital loss of $20,000. He has $5,000 worth of long-term gains on collectibles (the 28 percent group.) He also has a Section 1250 gain of $15,000 (25 percent group), and $25,000 worth of long-term gain from the sale of stock (15 percent group). Hal's net capital gain is $25,000 (total gain of $45,000 - $20,000 short-term loss). His short-term loss completely offsets the $5,000 of collectibles gains and the Section 1250 gain of $15,000. Thus, Hal ends up with $25,000 worth of long-term capital gains, taxed at 15 percent.
Net capital losses
Capital losses are netted against capital gains. Up to $3,000 of excess capital losses is deductible against ordinary income each year. Unused net capital losses are carried forward indefinitely and may offset capital gains, plus up to $3,000 of ordinary income during each subsequent year. (The $3,000 limit is reduced to $1,500 for married persons filing separately.) For more information about capital losses, see Capital Gain Income and Loss. See also Losses.
Example(s): Assume Jane has a short-term capital gain of $1,200 and a short-term capital loss of $1,300, resulting in a net short-term capital loss of $100. She also has a net long-term capital gain of $600 and a net long-term capital loss of $4,200, resulting in a net long-term capital loss of $3,600. The excess of Jane's capital losses over capital gains is $3,700 ($100 + $3,600). This excess is deductible from ordinary income up to a maximum of $3,000 this year; the remainder may be carried over to future years.
How do you use the capital gains tax to lower your taxes?
Time your capital gain recognition
Careful planning may save you taxes. For example, you may be able to wait until next year before selling a capital asset so that your capital gain or loss is recognized when you may be in a lower tax bracket. Timing is important because capital gains increase your adjusted gross income (AGI). If you file married filing separately and your AGI is more than $79,975 in 2008 ($78,200 in 2007), or if you use any other filing status and your AGI is more than $159,950 ($156,400 in 2007), some of your itemized deductions may be phased out or disallowed. Personal exemption amounts will also be decreased or disallowed if your AGI reaches a specified threshold figure.
For more information, see Deductions and Exemptions.
Plan your year-end capital gain and loss status
If you realize a capital gain this year, you should (1) review your portfolio for potential losses, (2) recognize losses to offset your gain, and (3) use $3,000 ($1,500 if married filing separately) worth of losses (if applicable) to offset ordinary income.
If you have a capital loss this year (or have a loss carryforward), you should review your portfolio for gains for offset purposes. This may lower your overall tax liability.
For more information, see Year-End Investment Decisions.
For property held as an investment, elect to include gain in investment income
Taxpayers may elect to treat capital gains from investment property as investment income instead. If such an election is made, gains will be taxed at ordinary rates and can be used to offset investment interest expenses. This may be advantageous for taxpayers who have sufficient capital losses to offset capital gains, and insufficient investment income to offset investment interest expenses (remember that investment interest expenses can only be used to offset investment income, although they can be carried forward and used in future tax years).
Capital gains taxation of dividends
Under the 2003 and 2005 Tax Acts, long-term capital gains tax rates also apply to certain dividends received by individual shareholders from domestic and qualified foreign corporations (for taxable years beginning after 2002 and before 2011).
Such dividends must be reported on Schedule D along with other capital gains. However, capital losses cannot be used to offset dividend income taxed at long-term capital gains rates. Thus dividends increase net capital gains, but can't be used to reduce net capital gains to less than zero.
Many special rules and exclusions apply to the taxation of dividends. For more information, see Stocks: Tax Planning, Mutual Funds: Tax Planning, and Real Estate Investment Trusts (REITs).
Neither Forefield Inc. nor Forefield Advisor provides legal, taxation, or investment advice. All content provided by Forefield is protected by copyright. Forefield claims no liability for any modifications to its content and/or information provided by other sources.
Securities offered through Securities America Inc., Member FINRA/SIPC and advisory services offered through Securities America Advisors. Armstrong Advisory Group, Money Matters Radio and Securities America Inc. are unaffiliated. Representatives of Securities America Inc. do not provide legal or tax advice. Please consult with a local attorney or tax advisor who is familiar with the particular laws of your state.
Securities offered through Securities America, Inc., Member FINRA/SIPC and advisory and financial planning services offered through Securities America Advisors Inc. Susan Powers, Paul Hundley, Brendan Hayes, Kim Harris, Chuck Zodda, Representatives, Money Matters Radio, Armstrong Advisory Group and Securities America, Inc. are separate entities.