US Income Tax/Capital Gains and Losses

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US Income Tax
Introduction
Income
Gains and Losses
Capital Gains
Business Deductions
Personal Deductions
Tax Liability
Tax Credits

Gains and losses from the sale or exchange of capital assets receive separate treatment from "ordinary" gains and losses. Capital gains are taxed before income, at a significantly lower rate than ordinary gains. Capital losses, on the other hand, are only useful to offset capital gains and a small amount of personal income. As a result, tax planners often attempt to maximize capital gains while minimizing capital losses (i.e. reworking them into ordinary losses).

Capital assets[edit]

In the context of capital gains and losses, the word "capital" has a different meaning than it has in other areas of law. Capital assets are not necessarily those that are "capitalized" by businesses, for instance. The Code does not define "capital assets," but instead states that capital assets are not the following:

  • Business inventory (assets bought and sold in the regular course of business).
  • Business supplies.
  • Accounts .
  • Depreciable trade or business assets held for one year or less (including business real estate).
  • Copyrights and creative works created by or gifted to the taxpayer.
  • Government publications.
  • Hedging transactions.
  • Commodities derivatives held by brokers.

Any other asset is considered a capital asset.

Calculating capital gains and losses[edit]

Net capital gain[edit]

Most capital gains and losses are taxed as net capital gain. Net capital gain is taxed at 15% for taxpayers in the 25% tax bracket or above, and 5% for other taxpayers (unless they are below the minimum tax bracket, in which case they are not taxed).

The Code defines net capital gain as the excess of net long-term capital gain over net short-term capital loss. These two figures are reached by adding up the various long-term and short-term capital gains and losses realized in the taxable year. Gains and losses from assets held for over one year are considered long-term capital gains and losses, while gains and losses from assets held for one year or less are considered short-term capital gains and losses.

The calculation might look like this:

Long-term Short-term
Gains 2,000 2,000
Losses 10,000 4,000
Net gains 0 0
Net losses 8,000 2,000

Because there is no excess, there is no net capital gain. The net capital loss is $10,000.

Long-term Short-term
Gains 15,000 2,500
Losses 4,000 6,000
Net gains 11,000 0
Net losses 0 3,500

Because there is an excess of net long-term capital gain over net short-term capital loss, the excess $7,500 is taxable at the 5% or 15% rate. Which rate is used depends on which bracket the taxpayer is in.

Net capital losses[edit]

Net capital losses are used for offsetting.

Individuals can use up to $3,000 of capital losses to offset their income ($1,500 for a married person filing separately). In the above example, the taxpayer would be able to apply $3,000 of his or her net capital loss to reduce his or her taxable income by $3,000, leaving $7,000 in unused net capital loss.

Capital losses can also be carried over. If net long-term capital loss exceeds net short-term capital gain, the excess becomes long-term capital loss in the following year. If net short-term capital loss exceeds net long-term capital gain, the excess becomes short-term capital loss in the following year.

Corporations follow different rules. Their capital losses must first be carried back to each of the three preceding years, if possible. Any capital losses that cannot be applied against capital gains from the three previous years can then be applied against capital gains in the 5 succeeding tax years.

For example, assume that X Corporation has $50,000 in net capital losses in 2005. Their capital gains for the last three years are:

2002: 0
2003: 23,000
2004: 11,000

The net capital losses cannot be carried back to 2002 because there is no net capital gain to offset. $23,000 can be used to offset the capital gains in 2003, leaving $27,000. Another $11,000 can be used to offset the capital gains in 2004, leaving $16,000. This $16,000 can be used to offset any net capital gains that arise in the next five years.

Section 1231 assets[edit]

Many assets held for use in a trade or business receive separate treatment under Section 1231. These assets include those that are:

  • sold or exchanged, and
    • held for more than one year and
    • used for a trade or business and
    • depreciable and
    • not inventory or intellectual property, OR
  • converted (i.e. destroyed/stolen/condemned), and
    • used for a trade or business OR
      • held for more than one year and
      • held in connection with a trade or business or venture for profit.

Any gains and losses allowed under Section 1231 are added up. If gains exceed losses, the net gain is treated as long-term capital gain for that year. But if losses exceed gains, the net loss is treated as ordinary loss. This seems to give taxpayers the "best of both worlds" in a sense: they can receive the favorable capital gains rate for 1231 gains, and can treat 1231 losses as ordinary losses directly against their income.

There is one qualification that destroys much of this attractiveness: recapture. Under Section 1231(c), 1231 gains are treated as ordinary income to the extent of net 1231 losses over the past five years. This means that 1231 losses may only provide a temporary advantage: if there are 1231 gains within the next five years, they will be treated as ordinary income to the extent that they offset the prior loss.

Section 1245 recapture[edit]

The capital gain system is also tempered by Section 1245, which provides for recapture of prior depreciation deductions on personal property. When 1245 property is sold, depreciation is added to the adjusted basis to find the recomputed basis of the property. If the recomputed basis and the amount realized both exceed adjusted basis, the excess is treated as ordinary income, not capital gain. Any amount realized over the recomputed basis can be 1231 gain or capital gain.

For instance, assume a machine is purchased for $100, depreciated by $40 and sold. Its adjusted basis is $60: adding depreciation back in, its recomputed basis is $100, which exceeds adjusted basis. If the machine sells for $65, the amount realized also exceeds adjusted basis, and the $5 gain is treated as ordinary income. If the machine sells for $110, the first $40 gain is treated as ordinary income, and the remaining $10 may be capital gain or 1231 gain.

Section 1245 applies generally to depreciable personal property, but not to real property.