Understanding Capital Gains and Losses for Tax Purposes
1. General Scheme of Taxation
A. Classification of Gains and Losses
The classification of gains and losses depends on three key characteristics:
- The tax status (character) of the property:
- Capital asset (§1221)
- Business asset (§1231)
- Ordinary asset
- How the property was disposed of, e.g.:
- Sale or exchange
- Casualty, theft, or condemnation
- Termination of right or obligation to property
- Holding period (how long the asset was held):
- Short-term (one year or less)
- Long-term (more than one year)
2. Capital Assets (§1221)
A. What is a §1221 Property?
A capital asset is any asset other than the following:
- Inventory or property held primarily for sale in the ordinary course of business
- Accounts and notes receivable acquired from the sale of inventory or performance of services in the ordinary course of business
- Depreciable property or real estate used in a business
- Supplies regularly used or consumed in the ordinary course of a business
- Certain copyrights and artistic literary compositions created by the taxpayer or acquired by gift or nontaxable exchange from the creator
- U.S. government publication received from the U.S. government at a reduced price or as a lifetime gift from the original recipient
In general, capital assets are restricted to investment properties and personal-use assets.
Note: No asset is inherently capital or ordinary. The status (character) of a property depends on how the taxpayer used the asset and how long the taxpayer owned the asset before selling it.
3. Disposition of Capital Assets
Recognition of capital gain or loss usually requires a sale or exchange of a capital asset.
Special Cases of Capital Asset Disposition:
- Worthless Securities: Stocks and bonds that become worthless due to an insolvent issuer are treated as disposed of on the last day of the tax year (relevant for deciding holding period).
- Small Business Stock (§1244): Taxpayers can deduct this as an ordinary loss, with a maximum of $50,000 per individual ($100,000 if filing Married Filing Jointly – MFJ).
- Retirement of Corporate Obligation: If a taxpayer repurchases their debt or loan, any loss or gain is treated as capital.
- Patents: Transfer of a patent with all substantial rights is treated as the sale or exchange of a long-term capital asset.
- Franchises, Trademarks, and Trade Names (§1253):
- If the transferor retains no significant power, rights, or continuing interest, then capital gain or loss treatment is available (provided the property is a capital asset to the transferor).
- Otherwise, the payment is ordinary income (or deduction) for the transferor (or transferee).
4. Holding Period
A. General Rules
- Short-term: Held for one year or less (≤ 1 year).
- Long-term: Held for more than one year (> 1 year).
Note: A capital asset acquired on the last day of any month must not be disposed of until on or after the first day of the thirteenth succeeding month.
B. Special Holding Period Rules
- The holding period of property acquired in a like-kind exchange includes the holding period of the former owner (if the former owner held the property as a §1221 or §1231 asset).
- If a non-taxable transaction includes the carryover of basis to the present owner (e.g., gifts), the former owner’s holding period is carried over as well.
- When property is sold in a disallowed loss transaction (e.g., related party sale or sale of personal-use asset), the purchaser begins a new holding period.
- The holding period for inherited property is treated as long-term for the heir, regardless of how long the property is held by the heir.
5. Tax Treatment of Capital Gains and Losses – Noncorporate Taxpayers
A. General Tax Treatment
Tax treatment depends on:
- Holding period
- Taxpayer’s regular tax rate
- Type of asset
B. Four Categories of Capital Gains
- Short-term: Taxed at ordinary income tax rates.
- Regular Long-term: Subject to preferential tax rates.
- 28% Property:
- Collectibles held more than one year (e.g., works of art, rugs, coins, stamps, etc.).
- Taxable portion of gain on sale of qualified small business stock.
- Taxed at no more than 28 percent.
- Unrecaptured §1250 Gain:
- Applies to depreciable real estate held more than one year.
- §1250 recapture is explained later in this chapter.
- Unrecaptured §1250 gain is taxed at a maximum of 25 percent.
Preferential Tax Rates for Long-term Capital Gains:
- 20 percent rate for taxpayers in the 39.6 percent bracket.
- 15 percent for taxpayers in the 25 to 35 percent bracket.
- 0 percent for taxpayers in the 10 or 15 percent tax bracket.
C. Capital Gain and Loss Netting Procedure
If there are multiple sales in a year, the character of net gains and losses must be determined through this procedure:
- Group all gains and losses into the four categories (i.e., short-term, 28% property, unrecaptured §1250 gain, and regular long-term).
- Net gains and losses within each category.
- Net long-term categories:
- If 28% property and unrecaptured §1250 gain are of opposite signs, net them.
- If the above result and regular long-term amount are of opposite signs, net them. If the regular long-term amount is a loss, offset against the highest taxed gain first.
- If results of step 3 and the net short-term amount from step 2 are of opposite signs, net them. If the short-term amount is a loss, offset against the highest taxed gain first.
Note: This procedure offsets capital losses against the highest-taxed gain first. Net capital losses are deductible at $3,000 total per year; any excess carries forward to future years. Short-term losses carry forward as short-term losses; long-term losses carry forward as long-term losses.
6. Tax Treatment of Capital Gains and Losses – Corporate Taxpayers
The tax treatment for capital gains and losses differs for corporate taxpayers:
- Capital gains are taxed at ordinary tax rates (i.e., no preferential tax rate treatment).
- Capital losses can only be offset against capital gains.
- There is a three-year carryback and five-year carry-forward for net capital losses.