CAPITAL GAIN AND LOSSES
The Internal Revenue Code has long distinguished between income paid due to a person's individual
effort (such as wages or self-employment earnings), and income received from the profitable sale of assets known as "capital"
assets. Wages and salaries are classified as "ordinary" income. Gain from the sale of a capital asset
is termed a "capital" gain. Gains from the sale of capital assets which meet certain requirements are generally
accorded more favorable tax treatment than ordinary income.
BASIC TERMINOLOGY
There are several concepts
essential to understanding capital gains and losses.
Capital asset: The law defines the term "capital" asset in a
negative sense by first declaring that all types of property are capital assets, and then listing certain exceptions.
(See IRC Sec. 1221.) Assets such as stocks, bonds and other securities held by individuals are capital assets.
Some assets are not capital assets by definition, but may be treated as such if used in a trade or business, and sold or exchanged
at a gain.
Holding period: This
is the length of time an asset is owned, beginning on the day after it is acquired and ending on the day it is disposed of.
The amount of time an asset has been held impacts the tax treatment of any gain or loss when the asset is sold. The
law currently provides for two holding periods: short-term and long term. Short-term assets are those held exactly
12 months or less. Long-term assets are those held more than 12 months.
CAPITAL LOSSES
At
the end of a tax year, a taxpayer's capital gains and losses are totaled and compared. If losses exceed gains, a
taxpayer may use up to $3,000 of losses to offset other ordinary income ($1,500 if married filing separately). (See
IRC Sec. 1211(b).) Losses which exceed the $3,000 limit may be carried to future tax years until used up. If a
taxpayer dies during the year, any un-used capital loss is gone forever; it may not be carried over to future tax years.
CAPITAL GAINS
Ordinary income such as wages and salaries can be taxed at marginal federal income tax rates as high
as 38.6%. Short-term capital gains are treated as ordinary income, taxable at the taxpayer's highest rate.
Long-term capital gains are taxed at rates which are capped, and which may be less than a taxpayer's regular rate.
RECENT TAX LEGISLATION
The Taxpayer Relief Act of 1997 (TRA '97) brought major changes to the tax treatment
of capital gains and losses. In general, the Act lowered tax rates on long-term capital gains, and increased the holding
period required to qualify an asset as "long-term." The Act also completely changed the rules regarding taxation
of gain received from the sale of a personal residence.
The
changes made by TRA '97 were modified by new legislation and a series of technical corrections contained in the IRS Restructuring
and Reform Act of 1998. The 1998 legislation shortened the holding period required to qualify an asset sold in 1998
for the lowest capital gain rate and also clarified and simplified the rules for calculating capital gains and losses.
SPECIAL RULES FOR PERSONAL RESIDENCE
The Taxpayer Relief Act of 1997 also made major changes in the tax treatment
of gain from the sale of a personal residence. The Act amended the one-time exclusion from income of $125,000 after
age 55 provided for in IRC Sec. 121, and repealed the mandatory rollover of gain previously prescribed in IRC Sec. 1034.
Under the new law, a taxpayer may exclude from income up to $250,000 of
gain from the sale of a principal residence, if the taxpayer has owned and used the property as his or her principal residence
for at least two years of the five-year period ending on the date of the sale or exchange. Only one such exclusion is
permitted every two years. Sales or exchanges made before May 7, 1997 are not taken into account.
For married couples filing a joint return, the maximum exclusion amount is increased
to $500,000 if(a) either spouse meets the ownership requirement; (b) both spouses meet the use requirements, and (c) neither
spouse is ineligible because of the one sale every two years rule. If a married couple does not meet the requirements
for the $500,000 exclusion, the amount of gain eligible for exclusion is the sum of the amounts to which each spouse would
be entitled if they had not been married.
The Act also provides
a partial (prorated) exclusion for taxpayers who do not meet the requirements to qualify for the full $250,000 exclusion,
and who sell or exchange a principal residence because of changes in place of employment, health, or unforeseen circumstances.
The new rules were effective for sales or exchanges after 05/06/97.
TIMING OF CAPITAL GAINS TRANSACTIONS
It is important to note that a taxpayer generally controls when a capital
asset will be sold and can, therefore, choose the year in which a gain or loss is to be included in his or her taxable income.
SEEK PROFESSIONAL GUIDANCE
The income tax treatment of capital gains and losses is complex and often
confusing. Individuals facing decisions concerning the tax implications of the sale or exchange of a capital asset are
strongly advised to first consult with a CPA, IRS enrolled agent or other competent professional.
