A capital gain or loss results from the sale, trade, or exchange of a capital asset. Simply stated, when the resulting transaction nets an amount lower than the original purchase value of the capital asset, a capital loss occurs. When the resulting transaction nets an amount greater than the original value at purchase, a capital gain occurs. Capital gains and losses can either be short-term (when the transaction is completed within one year) or long-term (when the transaction is completed in more than one year). The period is determined from the day after acquisition of the asset to the day of its disposal. Capital gain/loss is a concept that affects small business owners in a number of ways—from the decisions they must make regarding their personal property and investments to the attractiveness of their businesses to outside investors. The factors relevant to capital gain/loss are the capital asset, the transactional event, and time.
The subject of capital gain/loss is the source of debate among analysts and in government and economic circles generally. The current philosophy centers on the benefits and efficiencies of capital accumulation and utilization. To encourage capital formation and investment, the federal tax codes tax capital gains at lower rates than ordinary income. In 2005, the maximum tax rate on a long-term capital gain was lowered from 20 percent to 15 percent, compared to the maximum income tax rate of 35 percent. Two somewhat higher capital gains rates do apply to gains resulting from the sale of very specific items—a 25 percent rate applies to part of the gain from selling depreciated real estate, and a 28 percent rate applies to gains from the sale of small business stock and/or collectibles.
Tax rate changes that were made in 2003 were based on the theory that a lower capital gains tax will encourage people to sell stock and other assets. This, in turn, is expected to increase the federal government's tax revenues. Many believe that lower capital gains tax rates have a beneficial effect on investments in small businesses. Such investments tend to provide investors with income via an appreciation in stock price (which is taxed as a capital gain) rather than via dividends (which are taxed as ordinary income).
Everything one owns for personal use, pleasure, or investment is a capital asset. This includes: securities; a residence; household furnishings; a personal car; coin and stamp collections; gems and jewelry; and precious metals. Since property held for personal use is considered a capital asset, the sale or exchange of that property at a price above its purchase price, or basis, thus results in a capital gain, which is taxable. If one incurs a loss on that property from a sale or exchange, however, the loss cannot be taken as a tax deduction unless it resulted from a personal casualty loss, such as fire, flood, tornado, or hurricane. Other types of property and investments also have some irregularities in their treatment as capital gains or losses for tax purposes.
Investment Property, Collectibles, Precious Metals, and Gems
All investment property is also considered 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 sales transaction. For example, a person who owns stock in a growing technology company may see the price of that stock appreciate considerably over time. For a gain to be realized, however, the investor must actually sell shares at a market price higher than their original purchase price (or lower, in the case of a capital loss). Section 1244 of the federal revenue code treats losses on certain small business stocks differently. If a loss is realized, the investor can deduct the amount as an ordinary loss, while he or she must report any gain as a capital gain.
Sale of a Home
The sale of a personal residence enjoys special tax treatment in order to minimize the impact of long-term inflation. For most people, a residence is the largest asset they own. While some appreciation is expected, residences are not primarily used as 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 purchase of new homes, the tax code does not require reporting a capital gain if the individual purchases a more expensive house within two years. In addition, individuals are entitled to exclude for tax purposes up to $250,000 and married couples up to $500,000 of capital gains from the sale of a home, provided they have lived in the home as a principal residence in two out of the previous five years. As of 2005, this exclusion was available to taxpayers every two years.
DETERMINING THE BASIS
Capital gain/loss is calculated on the cost basis, which is the amount of cash and debt obligation used to pay for a property, along with the fair market value of other property or services the purchaser provided in the transaction. The purchase price of a property may also include the following charges and fees, which are added to the basis to arrive at the adjusted basis:
- Sales tax
- Freight charges
- Installment and testing fees
- Excise taxes
- Legal and accounting fees that are capitalized rather than expensed
- Revenue stamps
- Recording fees
- Real estate taxes where applicable
- Settlement fees in real estate transactions
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 capital gain/loss.
NET GAIN OR 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, net long-term gain/loss is the difference between long-term gains and losses. 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 15 percent (5 percent for those whose income tax rate is either 10 or 15 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 a year until the entire capital loss is written off.
Bhattacharya, Sudipto, and George M. Constantinides. Theory of Valuation. World Scientific, 2005.
Dixon, Daryl. "Gaining on the Capital Gains Tax." The Bulletin with Newsweek. 13 April 1999.
Dixon, Daryl. "Two for the Money: Plans to Reduce Taxes on Capital Gains." The Bulletin with Newsweek. 22 June 1999.
Goold, Linda. "How Low Can You Go? New capital gains tax rates pose interesting choices for exchangers." Journal of Property Management. January-February 2004.
Kadlec, Daniel. "Capital Gain = Market Pain?" Time. 18 August 1997.
Murphy, Kevin E. and Mark Higgins Concepts in Federal Taxation 2005. Thomson West, 2004.
Santoli, Michael. "Profiting from Losses: These Tax Moves Can Help You Play Scrooge to the IRS." Barron's. December 6, 1999.
Yeager, Holly. "House Passes Bill to Extend Tax Cuts Capital Gains." The Financial Times. 9 December 2005.
Hillstrom, Northern Lights
updated by Magee, ECDI