A capital gain is a profit made from the sale of any capital asset where the sale price exceeds the purchase price of the investment (called the investment's cost basis). If you lost money on an investment, then you incurred a capital loss.
What is a Capital Asset?
Capital assets are investments such as stocks, mutual funds, bonds, real estate, precious metals, coins, fine art, and other collectibles. When the capital asset is sold, if your investment has an increase or decrease of value, you are taxed on the change of value of that asset. Investments may also produce income in the form of interest, dividends, rents, and royalties. Income produced by investments is taxed as the income is generated.
Tax Treatment of Capital Gains
Capital gains are taxed differently, depending on what kind of capital asset you invested in and how long you held the asset.
Types of Capital Assets
There are special tax rates that apply to different types of capital assets, including the sale of collectibles, depreciable real estate, and certain types of small business stocks.
Capital Gains Holding Periods: Long Term & Short Term
Capital gains are taxed differently depending on whether your investment is considered long-term or short-term. How long you have held an investment is called the holding period.
The holding period is determined from the day after you bought your investment until the date you sell your investment. The IRS states, "To determine how long you held the investment property, begin counting on the date after the day you acquired the property. The day you disposed of the property is part of your holding period." (Publication 550; also refer to Revenue Ruling 70-598.)
The short-term holding period is one year or less. Short-term capital gains are taxed at ordinary income tax rates, which range from 10% to 39.6% for the year 2015.
The long-term holding period is more than one year. Long-term capital gains are taxed at long-term capital gains rates, which is usually less than ordinary tax rates. The long-term capital gains tax rate is either zero percent, 15%, or 20%, depending on your marginal tax bracket.
In addition, high income taxpayers may have a 3.8% unearned income Medicare contribution tax applied to their capital gains and other net investment income. Thus the highest tax rate that could apply to capital gains income is 39.6+3.8 = 43.4% on short term gains taxed at ordinary rates or 23.8% (20% + 3.8%) on long-term gains.
Tax planning for investors focuses on deferring the sale of profitable investments until you qualify for the discounted long-term capital gains tax rate.
Investors need to keep track of all their investments. This information is essential for calculating the amount of capital gain you have. You must know what you bought, how much you invested, your brokerage fees and commissions, and when you bought the investment. You must also know date of sale for your investment, the gross proceeds from the sale, and any fees or commissions you paid to sell.
You may want to use a spreadsheet or personal finance software to keep track of this information. Personal finance programs can provide more robust investment tracking features than a spreadsheet. Your broker might also have tools for tracking cost basis, gains and losses. There are also specialized investment recordkeeping software, such as GainsKeeper.
You should also retain any reports and trade confirmations as backup documentation. Annual reports from your broker are especially helpful, and these should be kept along with your other tax-related documents. Trade confirmations and gain/loss reports will come in handy when preparing your tax return.
If you are going to use a spreadsheet to track your investments, here's a suggested Capital Gains Spreadsheet Format. This spreadsheet is designed mostly to help you organize your investment purchases and sales for preparing your tax return.
Federal Tax Forms Relating to Capital Gains
Capital gains are reported using Schedule D and Form 8949. Taxpayers may need to use the Qualified Dividends and Capital Gain Tax Worksheet, found in the Instructions for Form 1040, when calculating the proper amount of federal income tax.
All the details regarding individual trades are reported on Form 8949, and totals from Form 8949 are then summarized on Schedule D, and then transferred to Form 1040. Form 8949 is organized much like a spreadsheet, with all the essential information about each investment you sold during the year. Capital gain or loss is reported for each transaction. Then your total gains or losses are figured. You will have either a net profit or a net loss from all your trades. There are special rules for capital losses, such as annual limitations on capital losses and Wash Sale Rules.
Determining the Tax Rate
The capital gains tax rates are determined by the type of investment asset and the holding period of the asset.
In addition to the federal capital gains tax rates, your capital gains will also be subject to state income taxes. Many states do not have separate capital gains tax rates. Instead, most states will tax your capital gains as ordinary income subject to the state income taxes rates.
Tax Rate on Short-Term Capital Gains
Capital gain income from assets held one year or less is taxed at the ordinary income tax rates in effect for the year, ranging from 10% to 39.6% for the year 2015.
Tax Rate on Collectible Assets
Long-term investments in collectibles are taxed at a flat 28%. Short-term investments in collectibles are taxed as short-term capital gains at your ordinary income tax rates. Collectibles include the following items:
- precious metals,
- precious gems,
- rare rugs,
- alcoholic beverages, and
- fine art.
However, certain precious metal coins and bullion are considered regular investment assets and are not considered collectibles for tax purposes under Internal Revenue Code Section 408(m)(3). See also, Publication 17, Your Federal Income Tax, chapter 16.
Tax Rate on Recaptured Depreciation of Real Property
Real property that has been depreciated is subject to a special depreciation recapture tax. A special 25% tax rate applies to the amount of gain that is related to depreciation deductions that were claimed or could have been claimed on a property. The remainder of the gain will be taxed at ordinary tax rates or long-term gain tax rates, depending on how long the property was held. For more details on depreciation recapture, refer to Publication 544, Sales and Other Dispositions of Assets, chapter 3, section on Depreciation Recapture.
Fixed assets used in your business are taxed as ordinary gains. Business assets include all furniture, equipment, and machinery used in a business venture. Examples include computers, desks, chairs, and photocopiers. Ordinary gains are reported on IRS Form 4797. Refer to Publication 544, Sales and Other Dispositions of Assets for further details about selling business assets.
Small Business Stock
Capital gains and losses on small business stock may qualify for preferential tax treatment. Gains may be partially excluded under Section 1202, if the company had total assets of $50 million or less when the stock was issued. Losses may be treated as ordinary losses up to $50,000 per year under Section 1244, if the company had total paid-in capital of $1 million or less.
Small business investors can request that companies certify their stock as qualifying under Section 1202, Section 1244, or both, at the time they make an investment in the company.
Gains on small business stock are taxed at 28% after any exclusion. Ordinary losses on Section 1244 stocks can reduce other ordinary income, such as wages.
For more details on these two provisions for small business stock, refer to Publication 550, Investment Income and Expenses, chapter 4, especially the section on Gains on Qualified Small Business Stock.
Tax Rate on Long-Term Capital Gains and Qualified Dividend Income
Capital gain income from assets held longer than one year are generally taxed at special long-term capital gains tax rates. The rate that applies depends on which ordinary income tax bracket you fall under.
- 0% applies to long-term gains and dividend income if a person is in the 10% and 15% tax brackets,
- 15% applies to long-term gains and dividend income if a person is in the 25%, 28%, 33%, or 35% tax brackets, and
- 20% applies to long-term gains and dividend income if a person is in the 39.6% tax bracket.
Tax Rates on Dividend Income
Dividends are classified either as ordinary dividends or as qualified dividends. Ordinary dividends are taxed at ordinary tax rates for whatever tax bracket you are in. Qualified dividends are taxed at the long-term capital gains tax rates of zero percent, 15% or 20% rates. To be eligible as a qualified dividend, the dividends must be from a domestic corporation or a qualifying foreign corporation and you must hold the stock "for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date" (Publication 550).
Capital Gains Tax Rates
|If your tax bracket is:||Then short-term gains are taxed at:||And long-term gains are taxed at:|
|Except for the following types of assets:|
|Collectibles||Ordinary tax rates||28%|
|Depreciation recapture||Ordinary tax rates||25%|
|Qualified small business stock||Ordinary tax rates||28% after exclusion|