Tax planning and compliance for investors
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By Kaye A. Thomas
Updated April 9, 2011
A quick overview of capital gains and losses.
Buy low, sell high. Do that and you'll be a successful investor. You'll also have capital gains. The tax treatment of capital gains — and capital losses — is one of the longer subjects we deal with in this web site. This page covers the basics.
Investors receive two types of income: ordinary income and capital gains. Ordinary income includes dividends and interest you receive. You have a capital gain when you sell a capital asset for a profit. Any asset you hold as an investment (stocks, bonds, real estate, for example) is a capital asset.
Of course, you can also lose money when you sell a capital asset: a capital loss.
Capital gains are better than ordinary income for two reasons. First, you don't pay tax on a capital gain until you sell the asset. Normally you can choose whether to sell sooner or later, so you control the timing of your gain or loss. For example, you can decide to sell late in December or early in January, depending on which year you want to report your gain or loss. Generally speaking, you don't have that kind of choice with ordinary income, such as interest and dividends.
Capital gains have another big advantage over ordinary income: they're taxed at special rates. To qualify for these rates you must have long-term capital gains. Short-term capital gain is taxed at the same rates as ordinary income.
A capital gain or loss is long-term if you held the asset more than one year (at least a year and a day) before you sold it. At that point you're entitled to a special capital gain rate. In most cases the rate will be 15% (0% if the gain falls in a tax bracket below 25%). There are exceptions for certain types of assets.
The 15% (or 0%) rate should always produce some savings. If your tax bracket for ordinary income is 10% or 15%, the rate on this category of capital gain is 0%; if your ordinary tax bracket is 25% or higher, the rate on this category of capital gain is 15%.
Your capital gain from a sale is measured by the difference between the amount realized in the sale and your basis in the asset you sold. Roughly speaking, the amount realized is what you received on the sale — usually measured by the sale price minus the brokerage commission. Your basis is based on your cost (usually the purchase price plus the brokerage commission) but may be adjusted as a result of various events. For example, if your stock splits while you own it, the basis splits, too.
Example: You buy 100 shares of XYZ at $35, paying $3,500 plus a brokerage commission of $20. Your basis is $3,520. Later, you sell when the stock is at $39. You receive $3,900 minus a brokerage commission of $20, so your amount realized is $3,880. Your capital gain is $3,880 minus $3,520, or $360.
If your basis is greater than the amount realized, you have a capital loss.
Capital losses are used first to offset capital gains. If there are no capital gains, or if the capital losses are larger than the capital gains, you can deduct the capital loss against your other income — up to a limit of $3,000 in one year. If your overall capital loss is more than $3,000, the excess carries over to the next year. In other words, you treat the extra portion as if it were an additional capital loss in the following year.
Example: In 2011 Ted had a $4,000 capital gain, and a capital loss of $11,400. He used $4,000 of the capital loss to offset the capital gain: that left a net capital loss of $7,400. He claimed $3,000 of the loss on his 2011 return. The effect was to reduce his taxable income by $3,000. Ted was in the 28% bracket, so the loss decreased his 2011 income tax by $840. The remaining $4,400 of capital loss carried over to his 2012 return. In 2012 he had a $500 capital gain and no capital losses except for the carryover. So he used $500 of the $4,400 carryover to offset the gain, leaving a capital loss of $3,900. Once again, Ted deducts $3,000 of the loss — and carries over the remaining $900 to 2013.
The tax law contains rules designed to prevent taxpayers from creating artificial capital losses. One rule you should be familiar with is the wash sale rule. This rule says you can't claim a loss from sale of a security (such as stock) if you buy the identical security as a replacement within the period beginning 30 days before the sale and ending 30 days after the sale. So if you sell XYZ for a loss on December 30 and buy the same stock on January 5 of the next year, you won't get a loss deduction for the sale on December 30. You need to wait at least 31 days to repurchase the stock if you want to claim the loss. Click here for details on this rule.
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