Capital Gains and Losses
Capital Gains and Losses
What It Means
Capital assets is a financial term that refers to everything a person owns for both personal use and investment, such as homes, cars, jewelry, computers, household furnishings, and stocks and bonds. When the value of a capital asset increases from its original purchase price, the owner is said to have experienced a capital gain. If the value of a capital asset decreases after the purchase, then the owner suffers a capital loss.
For example, if a person bought a house for $120,000 and five years later sold it for $150,000, that person would have a capital gain of $30,000. On the other hand, if the house sold for only $100,000, the person would realize a capital loss of $20,000. To use an example involving the stock market, if an investor purchased 10 shares of stock in the ABC Corporation for $100 per share (an investment of $1,000) and later sold those 10 shares for $110 per share (for a total of $1,100), that person would realize a capital gain of $100.
Both capital gains and capital losses are measured at the point of sale of the asset. This means that if a house purchased at $150,000 were later estimated to be worth $180,000, that additional $30,000 would only be regarded as a capital gain if the house were actually sold for $180,000. If the owner decides to keep the house, then no capital gain has been realized. The potential profits from unsold assets are called unrealized capital gains.
When Did It Begin
When a person sells a capital asset for more than he or she originally paid for it, he or she makes a profit called a capital gain. But although profit and capital gain and both refer to making money, there is an important distinction to be made between the two terms. Profit is a word that refers to money made on any sale; the concept has existed for many centuries. Capital gain is a more recently coined term that is used in the context of filing taxes.
The U.S. government first imposed income taxes (taxes on what people earn through their jobs and investments) during the Civil War (1861–65). At the time capital gains were counted as regular income and taxed at the same rate. It was not until 1913 that Americans were taxed separately for capital gains. Initially this was a simple 7 percent tax on all capital gains. Since 1922, however, capital gains tax laws in the United States have changed frequently and become complicated. By the start of the twenty-first century, tax rates on capital gains had come to depend on a number of factors, including the investor’s overall income level and the amount of time an investor owned an asset before selling it.
More Detailed Information
When setting income tax rates, the United States Internal Revenue Service (IRS) makes a distinction between long-term and short-term capital assets. Assets that the investor has owned for more than a year are long-term assets; assets that have been held for less than a year are short-term assets. For any capital gains on long-term assets, the tax rate is lower than the rate for short-term assets and regular income. Capital losses, which can be deducted from ordinary income, can reduce the amount of taxes an individual owes. For example, if capital losses are greater than capital gains, a taxpayer can deduct up to $3,000 in capital losses from his ordinary income. This means that if a person declared $70,000 in salaries, tips, and wages but also recorded a net capital loss of $5,000 after selling stocks during the year, that person would subtract $3,000 (the maximum amount allowed) from his yearly total and report earnings of $67,000 instead of $70,000.
Calculating taxes on capital gains and capital losses is an involved process. First the investor must separate long-term capital gains and losses from short-term capital gains and losses. Short-term gains are taxed as ordinary income, which means that, depending on his or her tax bracket (the category that determines what percentage a person must pay as tax; it increases as income increases), an investor can pay as much as 38 percent tax on a short-term capital gain. Long-term capital gains, on the other hand, can be taxed at rates varying from 8 percent to 28 percent, depending on the investor’s tax bracket and on the type of asset that was sold. Most long-term capital gains are taxed at or around 15 percent. The higher rates for long-term capital gains apply to the sale of some collectibles and small-business stock. The lower rates on long-term capital gains (those tax rates in the 8 to 10 percent range) apply to investments that have been held more than five years.
After distinguishing between short- and long-term capital gains and losses, the investor must calculate the net (overall) capital gain or loss. This figure indicates whether the investor had a net profit or a net loss from his or her sale of all capital holdings that year. To determine this number, short-term capital losses are subtracted from short-term capital gains, and long-term capital losses are subtracted from long-term capital gains. Following a formula determined by the IRS, the short-term capital losses or gains are then calculated against the long-term losses or gains to arrive at a net figure. Although no investor wants to lose money, capital losses are not always bad for taxpayers. For example, a person who has earned a large profit in short-term capital gains can reduce the final amount owed in taxes by selling some capital assets at a loss. This is called loss harvesting or tax gain.
If homeowners earn a profit on the sale of their home, they do not necessarily have to worry about paying high capital gains taxes. According to 1997 tax laws, a homeowner does not have to pay capital gains taxes if he purchases a more expensive house within two years of the sale of his previous home. In addition, homeowners are able to subtract the cost of improvements to the home from their capital gains. This law applies only to the sale of a homeowner’s principal residence and does not include vacation homes or time-shares (vacation homes co-owned by a group of people who take turns staying there).
Starting in 1997 people who had invested in housing realized tremendous capital gains. From 1997 to 2005, housing prices in the United States rose 73 percent. During that span many other countries experienced a similar boom in their housing markets. For example, prices rose 244 percent in South Africa, 192 percent in Ireland, and 145 percent in Spain. Economists attribute this surge to two factors. First, low interest rates encouraged people to borrow money for homes. Second, in general most middle-class investors view real estate as a safer venture than the stock market.
After 2005, however, housing prices leveled and even dropped in some countries. For example, although prices in Great Britain rose 154 percent from 1997 to 2004, they declined by 20 percent from 2004 to 2006. In the United States interest rates began to rise steadily, and Americans therefore bought fewer second homes and rental properties. Despite this downturn, economists predicted that the housing market would flatten rather than collapse, as the stock market probably would if stock prices were to drop dramatically. Statistics show that an investor is far less likely to sell a house for a loss than a stock. Also, regardless of market conditions, economists reason that people will stay in the real estate market because a home is a necessity.