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. The increase or decrease in the value of such investments is taxed when the capital asset is sold. 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 GainsCapital gains are taxed differently, depending on what kind of capital asset you invested in and how long you held the asset.
Types of Capital AssetsThere 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 TermCapital 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 2013.
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.
Investment Record-KeepingInvestors 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 GainsCapital 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.