Calculation of capital gains (or losses) is necessary to properly calculate overall US Federal income taxes since capital gains are treated as income. For assets held one year or longer, the tax rate on capital gains is generally less than the rate on “ordinary” income such as wages and salaries.
For purposes of financial accounting and taxes, just about anything you own is termed an “asset”, including intangibles such as a copyright.
The term “capital asset” is used to classify assets that are expected to have a relatively long lifespan. Such assets are generally considered durable, as opposed to items (such as food) that are consumed quickly. However, as you might expect, there are exceptions and quirks of tax rules that make determination of whether an asset is “capital” or not (for tax purposes) a challenge.
When you sell an asset, the monetary value received (which might include something other than money) may be more or less than the amount you paid to buy the asset. For a capital asset, if the sale price is greater than the purchase price, the profit is termed “capital gain”. If the sale price is less, you have a capital loss that may (or may not) be used to offset capital gains.
Although the basic concept of profit (gain) and loss is quite simple, calculation of taxes on capital gains is rather more complicated. Actually performing the calculations is relatively easy. More challenging is finding, reading and interpreting instructions. Accurate determination of gain or loss often depends on numerous factors. In recent years, tax regulations relative to capital gains have become more complex.
The IRS web site provides information to help decipher regulations; start with their brief overview; “10 Facts About Capital Gains And Losses”.
The following IRS publications are easily downloaded;
Publication 523; Selling Your Home
Publication 544; Sales and Other Disposition of Assets
Publication 550; Investment Income and Expenses
Publication 551; Basis of Assets
Publication 334; Tax Guide For Small Business
See Publication 544 (Section 2; page 21) for basic tax rules. Go to Section 4 (page 35) to get started on reporting requirements. Instructions for Schedule D also include key information.
Before preparing a tax return, the following key terms must be understood;
Capital Asset – See Publication 544 (pages 21, 22) for basic explanation. However, for various assets, specific tax rules are more important than this general definition. Although not foolproof, the basic quality of a capital asset is that it is durable, meaning it will last a relatively long time compared to assets that are consumed in a short time.
Basis – Shorthand for initial cost or purchase price. However, basis of assets obtained via inheritance or gift require careful evaluation. See Publication 551 for more detailed discussion.
Adjusted Basis – Initial cost adjusted (up or down) by various events and activities, as defined by tax regulations. Depreciation is one typical adjustment. See Publication 551 for further explanation.
Fair Market Value – Figuring “fair market” value is somewhat subjective. Theoretically it is the price set by the impartial “market”. See the IRS explanation in Publication 544 (page 3).
Personal-use Property – Property that you personally own and use (Publication 544, page 22).
Investment Property – Stocks, bonds and similar assets (Publication 544; page 22). This category does not include property that produces rental income.
Adjustment Of Basis
To figure gain or loss, the adjusted basis must be determined. Gain or loss is then equal to the sales price minus adjusted basis.
For further discussion, adjusted basis is designated as “AB” and the amount of adjustment (up or down) is designated “AM”.
An adjustment (AM, up or down) of original basis results in the opposite effect (down or up) on the eventual gain (with loss considered a “gain” of negative value). If the original basis is reduced by AM, the eventual gain is increased by the same AM amount, compared to what would have been the gain without the reduction in basis. If the basis is increased by AM, the eventual gain is decreased by AM.
Depreciation that was deducted on a Federal tax return (at any prior time) decreases the basis of an asset, since the depreciation is effectively part of the original cost. Therefore, when the asset is sold, the gain is increased by the amount of depreciation, compared to what the gain would have been without any depreciation having been taken (and deducted).
Treatment Of Capital Losses
Profit (gain) on sale of a capital asset will generate capital gains tax, unless the gain can be offset by a capital loss, in accordance with tax rules. However, many net losses are either limited or not deductible.
For “personal property” a loss may not be deducted unless caused by casualty or theft. Financial assets (stocks, bonds) are considered “investment property”, not personal property.
Sale of House
Large gains may be realized from sale of a house used as a private residence. However, tax rules allow an exclusion of $500,000 (couple) and $250,000 (single) as long as; (1) Property has been owned for 2 years and used as private residence at some time during prior 5 years and, (2) Exclusion has not been taken during prior 2 years. “Exceptions” may also apply; see instructions for Schedule D.
See Publication 544 (page 5) for rules on foreclosures. The (former) owner may be liable for capital gains tax in some situations!
Explanation provided in basic IRS publications may not be completely adequate for any specific situation. One way to obtain a “ruling” is to call the IRS directly.
Another way is to simply make your best determination. Of course, if the potential effect of such determination involves a large amount of taxes, you should obtain competent advice from a tax professional or the IRS (in writing).
Tax Rates For Capital Gains
For assets held less than one year (“short term”), the tax rate for capital gains is the same as for ordinary income. For assets held one year or longer (“long term”), the tax rate is typically less.
In the past, a quick glance at Schedule D revealed tax rates for long term capital gains. However, today there is no way to understand capital gains tax rates today by simply looking at Schedule D.
History of capital gains tax rates (back to 1988) is summarized by the Tax Foundation;
For capital assets sold in 2008, 2009 and 2010, there was no capital gains tax on long-term capital gains for tax rates of 10% and 15%. For all others, the tax rate was 15%. This rate structure has been retained for 2011 and 2012 as the “Bush-era” tax cuts have been extended.
Actually “figuring” the tax is not quite as simple as multiplying capital gains by 15 percent. However, Schedule D “leads” you to the result.
Unless the current rates are extended yet again, starting in 2013, capital gains tax rates will increase. For those in tax bracket of 28% and 31%, the rate will be 20%, as it was before May 6, 2003.
As part of the new health care law, starting in 2013 a 3.8-percent surcharge will be added to the capital gains tax rate for those in the top two tax brackets (36% and 39.6%), so that the rate will be 23.8%.
Preparing Schedule D
Schedule D is the basic form used to report capital gains. Financial assets (stocks, bonds) will likely be the most frequent type of asset listed.
Brokerage firms typically provide detailed annual listing of stock transactions, including key information required for filing Schedule D.
Listed on first page of Schedule D (including any attachment) are short term and long term gains (and losses).
“Capital Gains Distributions” are reported under the long term list. Such distributions are generally reported on a 1099-DIV form by mutual fund or real estate investment trust (REIT).
If amounts listed on lines 18 and 19 are both zero, fill in “Qualified Dividends and Capital Gains Tax Worksheet” found in the instructions to Form 1040. Otherwise, use “Schedule D Tax Worksheet” found in the instructions for Schedule D.
Line 18 basically includes gains (or losses) from sale of “collectibles”. Line 19 is for “Section 1250” property, which involves “recapture” of previous depreciation if necessary according to tax rules (which can be complex).
“Qualified Dividends” worksheet is easy to complete, as long as you have the “qualified dividends” value to list on line 2 (from line 9b of Form 1040). “Schedule D Tax Worksheet” takes somewhat more time.
Calculating “qualified dividends” (which typically end up taxed at the lower capital gain rate) is a task best “delegated” to the brokerage firm. Amount of “qualified dividends” is most often less than total dividends received each year if dividends are obtained from several sources.