Understanding Individual Capital Gains and Losses by Jeffrey M. Mutnik, CPA/PFS
Capital assets include almost everything owned for personal use or investment purposes, including houses, furnishings, cars, artwork, bonds and shares of stocks. Understanding the resulting tax liabilities or deductions that apply when taxpayers sell these assets is an important step in an efficient tax-planning process.
What is a capital gain?
A capital gain is the profit taxpayers earn when they sell an asset for more than the original price they paid to acquire it, also known as the basis. Capital gains are considered income, which taxpayers must report on their tax returns and for which taxpayers whose income exceeds statutory thresholds may be subject to an additional 3.8 percent Net Investment Income Tax.
What is a capital loss?
A capital loss is the shortfall taxpayers incur then they sell an asset for less than the basis. These losses are limited in their usefulness for several reasons: short-term losses offset short-term gains to determine if there is overall net short-term gain or loss; similar computations are made for long-term transactions; and the net short- or long-term gains/losses are combined to determine if there is an overall capital gain or loss. When taxpayers’ capital losses exceed their capital gains, they may deduct from their income the excess, up to $3,000 per year (or $1,500 for married filing separately), as a loss on their tax returns. Losses exceeding these deduction limits are suspended on their tax returns and are available in the next year, where they may be applied to offset future gains.
What is the holding period and why does it matter?
Assets held for more than one year are considered long-term holdings. Assets sold one year or less from the date of purchase result in short-term capital gains or losses. Typically, long-term capital gains are treated more favorably (current maximum rate of 20 percent) than short-term gains, which are taxed at the maximum ordinary income tax rates (currently 39.6 percent). As a result, taxpayers may consider holding an appreciated investment for more than one year before selling it.
Many taxpayers would prefer to use short-term losses to offset income that will be taxed at the ordinary income rates, but the law requires net short-term losses to offset net long-term gains in the same year. Therefore, year-end planning should include analyzing holding periods of the recognized gains and potentially selling short-term appreciated assets before year-end. This could allow the net long-term gain to be taxed at the preferred 0 percent to 20 percent capital gains tax rate.
What about mutual funds?
Investments in mutual funds present unique situations for taxpayers. When these investment pools sell shares of stock in their portfolios for a profit, taxes can be due on the capital gains. Each year, to avoid their own income taxes, the funds pass these tax gains to their shareholders in the form of Capital Gain Distributions. Many are surprised to learn they owe taxes from their investments in mutual funds, whether or not the mutual funds have increased or decreased in value. Tracking the tax basis of mutual funds is often difficult but always important. Dividend reinvestments not only increase the number of shares owned, they also increase the overall basis of the fund held. Including this information in the basis of fund shares sold will limit the erroneous overstatement of gains on dispositions.
Can I deduct the loss I incurred on the sale of my home?
Taxpayers may deduct losses on the sale of property only when the property is held for investment purposes. Therefore, the sale of personal jewelry or a home for a loss is not deductible. However, any asset sold at a gain requires the gain to be reportable, whether the asset was held as an investment or not. Note that the sale of a primary home for a gain is not necessarily fully taxable. A gain up to $250,000 ($500,000 if married filing jointly) is excluded, when certain requirements are met.
The tax considerations of an asset sale should weigh heavily on taxpayers’ decision. While selling an investment for a loss can help to offset the liabilities of a significant capital gain, taxpayers should tread carefully with the guidance of experience tax and financial advisors.
About the Author: Jeffrey M. Mutnik, CPA/PFS, is a director in Berkowitz Pollack Brant’s Taxation and Financial Services practice. He can be reached in the CPA firm’s Ft. Lauderdale office at (954) 712-7000 or via email at email@example.com.