How are Capital Gains Recognized and Taxed?
The Federal long-term capital gains tax is a tax imposed on a taxpayer’s profits from the sale of assets that were purchased as an investment or for personal use and have been held for more than one year. A taxpayer only becomes liable for paying the capital gains tax when an asset is sold, therefore it is not imposed on the appreciation of assets the taxpayer is still holding.
Capital gains are a taxpayer’s profits from the sale of significant capital assets, including stocks, bonds, most real estate, art and jewelry.
How are Capital Gains Taxes Calculated?
As a general rule, a taxpayer’s capital gains tax liability is calculated based on net capital gains for the year, which are calculated by subtracting the taxpayer’s capital losses from his or her capital gains over that period. Capital gains are classified as either being short-term or long-term and each is treated differently for federal tax purposes. The difference in tax treatments for long- and short-term capital gains can greatly complicate your tax bill when you have capital gains and losses that fall into both categories.
Short-term capital gains are calculated based on the profits from investments that a taxpayer has held for less than one year and are taxed as if it was a taxpayer’s ordinary income.
Short-term capital losses are losses incurred on investments held by a taxpayer for less than one year. A taxpayer is allowed to use up to $3,000 in short-term capital losses each year to either offset short-term capital gains or income earned that year. Unused short-term capital losses may be used to offset long-term capital gains or rolled over to future tax years (See: “Combining Short- and Long-Term Capital Gains and Losses” below).
Long-term capital gains are calculated using the profits from the sale of assets held for longer than one year and are taxed separately from ordinary income. Traditionally, the federal long-term capital gains tax brackets were similar to those used for ordinary income. However, the Tax Cuts and Jobs Act created new long-term capital gains tax brackets based on a taxpayer’s income tax brackets that impose the tax at 0%, 15% and 20%.
Long-term capital losses are those incurred on investments held for more than one year that can be used to offset long-term capital gains for the year. If there is excess capital loss, then the remainder can be used as part of the short-term capital gains offset (up to $3,000 combined) with the unused portion of the loss being rolled over to future tax years (See below for additional explanation).
Below are the long-term capital gains tax brackets for 2019:
Long-Term Capital Gains Tax Rates for 2019
Based on Taxpayer’s Income
|Taxpayer Income Tax Filing Status||0% Rate||15% Rate||20% Rate|
|Single||Up to $3,375||$39,376 to $434,550||Over $434,550|
|Head of Household||Up to $52,750||$52,751 to $461,700||Over $461,700|
|Married Filing Jointly||Up to $78,750||$78,751 to $488,850||Over $488,850|
|Married Filing Separately||Up to $39,375||$39,376 to $434,550||Over $434,550|
As a general rule, because the long-term capital gains are taxed at a lower rate than ordinary income, therefore it usually benefits a taxpayer to hold on to capital assets for at least a year to avoid having the profits from their sale treated as ordinary income.
Combining Long- and Short-Term Capital Gains and Losses
Both types of capital losses can be carried forward to future tax years to offset capital gains in those years, but the losses retain their character as short- or long-term losses. That means unused short-term capital losses that are carried forward to future tax years must first be applied to short-term capital losses in those years. Likewise, unused long-term capital gains must first be applied to capital gains for those years. When there is a mix of short- and long-term gains and losses in a year, the character of the amounts carried forward are determined in the following manner:
If a taxpayer has both long-term capital gains and short-term capital gains in a tax year then the long-term capital gains will be subject to the long-term capital gains tax and the short-term capital gain will be taxed as ordinary income. There would be no net loss to carry forward.
Should a taxpayer have a long-term capital losses and short-term capital gains in a tax year and the short-term gains are greater than the long-term losses, the losses are subtracted from the gains and the taxpayer declares the resulting net short-term gain as ordinary income. If the long-term losses are greater than the short-term gain then the taxpayer is allowed to use up to $3,000 of the net loss as a deduction against ordinary income for that year and may carry the unused long-term loss forward.
When a taxpayer has long-term capital gains and short-term capital losses and the gains are larger than the losses the taxpayer is allowed to use the short-term losses to offset a portion of the long-term gains and the resulting net gain will be treated as a long-term capital gain. If the loss is larger than the gain then up to $3,000 of that net loss may be used to offset ordinary income with the unused portion carried forward as a short-term loss. w
A taxpayer who suffers both a long-term capital loss and a short-term capital loss the resulting combined net loss can be used to offset up to $3,000 in ordinary income for that tax year. However, things get complicated when both losses total more than $3,000 and some is carried over to the following year.
When the short-term loss is greater than $3,000 for tax year and there is also a long-term loss, then the short-term loss is applied to the $3,000 offset first, with the remainder carried over to the next year as a short-term loss along with the unused long-term loss. When short-term losses are less than $3,000, then the short-term losses are applied to the offset first, with the remainder of the offset being subtracted from the taxpayer’s long-term capital losses. The taxpayer’s unused capital losses will be carried forward to the following tax year.
The two types of gains and losses can be combined when one results in a loss. When a taxpayer’s short-term capital gains and losses plus his or her long-term capital gains or losses results in an overall loss in a tax year, the taxpayer is allowed to deduct that loss from income for that tax year. However, the taxpayer is limited to claiming $3,000 in capital losses in one tax year, with the unused portion being carried over to the following tax year. The carryover losses retain their character, so short-term losses may be deducted from income in future years while long-term losses are applied to long-term gains prior to being applied to short-term gains in the tax year claimed.
Notable Exceptions to the Standard Long-Term Capital Gains Tax Rate
The capital gains from some assets are subject to special treatment for the purposes of calculating the capital gains tax on profits from their sale. Those include the following:
- Some profits from the sale of owner-occupied real estate may be excluded from taxable income if the seller has occupied the home for two years or more. The first $250,000 of an individual’s capital gain on the sale of a home will be excluded from tax, and the first $500,000 of gain for couples filing jointly. However, this provision also prevents taxpayers from claiming a capital loss from the sale of a home.
- Real estate investors are allowed to deduct the depreciation from their income. Claiming that deduction also reduces the taxpayer’s basis in the building by the claimed amount, which will increase the capital gain that must be recognized upon its sale.
- High-income earners subject to the net investment income tax that is imposed on investment income, including capital gains, at 3.8% if the taxpayer’s modified adjusted gross income exceeds certain amounts. For married taxpayers filing jointly or a surviving spouse, the threshold is $250,000, for single taxpayers or heads of households it is $200,000 and it is $125,000 for married taxpayers filing separately.
- Sales of collectibles are taxed at 28%, regardless of taxable income.
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This post was written by Sean Allaband