Capital Gains and Losses

Capital gains and losses result from the sale or other disposition of either business property or investment property, such as real estate, stocks and bonds, and collectibles. Gains from personal property are taxable, but losses are not deductible. Short-term capital gains are taxed at ordinary marginal rates, while long-term gains are taxed more favorably, depending on the type of property and the income of the taxpayer.

Whenever property is disposed of, such as in a sale, the seller may realize a taxable net capital gain or deductible loss. Realized gain or loss is equal to the realized sales price minus the adjusted basis of the property.

Realized Gain or Loss = Amount Realized From Sale – Adjusted Basis of Property

The amount realized from a sale is the sale price minus any direct selling expenses, such as commissions or brokerage fees. The adjusted basis of the property generally includes its purchase price plus any direct buying costs, such as commissions or fees.

Recognized gain is the amount of realized gain that is includable in the taxpayer's gross income; recognized loss is the amount of realized lost that is deductible.

Realized gains or losses for nontaxable exchanges are not recognized; instead, gains or losses are postponed by assigning a carryover basis to the replacement property. The tax code refers to this as a nontaxable disposition, or a deferred-tax disposition. For instance, if you exchange property in which you have a $15,000 basis but that has a fair market value of $20,000 for other property that also has a fair market value of $20,000, then your basis in the new property is the $15,000 of the replaced property. So if you sell the new property for $22,000, you will have a recognized gain of $7,000. By contrast, a tax-free transaction is never recognized.

Special rules, which are discussed elsewhere, apply to the sale of mutual fund shares, tax-free exchanges of property, the sale of a principal residence, and sales of stock rights, wash sales, and short sales.

Capital Assets

The Internal Revenue Code defines a capital asset as any property not listed in IRC §1221 — §1221 includes inventory, accounts receivable, and depreciable property or real estate used in business, the disposition of which usually results in ordinary income or loss for the business. Other business assets, sometimes referred to as §1231 assets, generally result in ordinary gain or loss, which are reported on Form 4797, Sales of Business Property.

Tax law excludes certain assets as capital assets, including copyrights, musical or literary works, letters, memoranda, or other property that the taxpayer created with his own efforts or was acquired as a gift from someone who either created the property or had it prepared or created. This comports with the de facto tax policy objective of favoring the wealthy, by taxing work more heavily than investments, since assets created by one's effort will not benefit from the lower long-term capital gains tax. On the other hand, if someone bought a musical or literary work, then that asset will be treated as a capital asset, which may benefit from the lower long-term capital gains tax rate.

Collectibles are a special type of capital asset, which includes art, antiques, metals, gems, stamps and coins, bullion, and even alcoholic beverages that are held as investments. The long-term tax rate for collectibles is the lesser of 28% or the taxpayer's marginal tax rate; short-term gains are treated as ordinary income. So if a taxpayer in the 15% bracket sold a collectible, the gain would be taxed at 15% at most, regardless of the holding period. Other types of capital assets may also have different tax rates:

Long-Term Capital Gains Tax Rates for Different Types of Property and Levels of Income
Type of Property Maximum Rate
Collectibles28%
Qualified Small-Business Stock — §1202 Exclusion (Since 50% of stock is excluded from taxation, the effective tax rate = 14%.)28% (14%)
Unrecaptured §1250 Property (Real property for which depreciation has been claimed.)25%
 If regular tax rate on ordinary income is 39.6%, then the marginal capital gain rate within that bracket is:20%
 If regular tax rate on ordinary income is 25%, 28%, 33%, or 35%, then the marginal capital gain rate within these brackets is:
15%
 If regular tax rate on ordinary income is 10% or 15%, then the marginal capital gain rate within these brackets is:
0%
  • If the taxpayer is subject to a lower marginal rate on ordinary income, then that rate would apply to the capital gains.

The net profit earned from selling property depends on its tax basis when sold, which is adjusted for capital additions or depreciation.

Adjusted Basis of Property = Cost or Other Original Basis + Capital Additions – Depreciation or Other Capital Recoveries

The tax rates that apply to capital gains often depends on the holding period, which begins the day after the acquisition of the property and ends on the day of its disposition or sale. If the property was held for 1 year or less, then this disposition is considered a short-term capital gain or loss, which is treated as an ordinary income or loss. For property held longer, the disposition results in a long-term capital gain or loss, which usually receives better tax treatment. The holding period for patents and inherited property is considered long-term regardless of how long the taxpayer actually held the property. For an installment sale, if the gain was long-term in the year of the sale, then all succeeding payments will also be treated as long-term gains; otherwise, all installment payments will be considered short-term.

Netting Capital Gains with Capital Losses or up to $3,000 of Other Income

Although tax law always recognizes capital gain, it does not recognize losses for personal property — only for investment or business property. The losses of personal property cannot be used to offset any capital gains, including from other personal property. When offsetting other income, short-term losses must first be used, then long-term losses:

If the taxpayer dies with losses carried over from prior years that exceed the $3,000 limit ($1,500 limit for married filing separately), then the losses cannot be used to offset any capital gains either by the taxpayer's estate or by the surviving spouse. The IRS has held, however, that the net capital loss of a dead spouse may be claimed by the surviving spouse on a joint return that is the final return for the dead spouse.

Generally, capital losses are not allowed on dispositions of property between related parties, which includes ancestors and descendants, and siblings, whether whole or half blood. Losses are also disallowed between taxpayers and legal entities, such as a corporation, where the taxpayer has a controlling interest, including interests shared by family members or other legal entities where the taxpayer or his family members have a controlling interest. However, if a loss was disallowed between related parties and if the acquiring party resells the property at a profit, then the disallowed portion is not taxable.

How Capital Gains and Qualified Dividends Are Taxed

The tax treatment of the gain or loss depends on the type of property sold and the length of time that it has been held. Property sold in a given tax year, for which the seller will be receiving payments in later years, may report the sale as an installment sale, using Form 6252, Installment Sale Income, where the gain can be distributed over the installment period.

Capital assets are reported on Form 8949, Sales and Other Dispositions of Capital Assets. Part I lists short term gains or losses and Part II lists long-term gains or losses. The taxpayer may also receive Form 1099-B, Proceeds from Broker and Barter Exchange Transactions from brokers showing the taxpayer's basis in the security sold, which determines the net profit. The calculations on Form 8949 are transferred to Schedule D, Capital Gains and Losses of Form 1040, where short-term and long-term gains or losses are combined to yield a net gain or loss. If the only source of capital gains or losses is mutual funds or real estate investment trusts, then Schedule D is unnecessary. The capital gains or losses from a pass-through entity, such as a partnership, S corporation, estate or trust are reported on Schedule K-1, the results of which are transferred to Schedule D. However, C corporations pay the same rate on capital gains as for ordinary income.

For years, the long-term capital gains rate was a flat rate of 15%. In 2011, the flat rate was replaced with a marginal rate of 0% and 15%, and in 2013, an additional marginal rate of 20% has been added. The income levels of the capital gains marginal rate is related to the marginal rate applied to adjusted gross income (AGI), but at different income levels. For instance, the top of the 0% bracket for the capital gains marginal rate is equal to the top of the 15% tax bracket for AGI, and the top of the 15% tax bracket on capital gains corresponds to the start of the 39.6% AGI tax bracket, so the 20% rate applies to the investment income that, when combined with earned income, exceeds the start of the 39.6% bracket. Although the marginal tax on capital gains only applies to long-term capital gains, the income level is determined by the taxpayer's total taxable income. The same rates also apply to qualified dividends, which are treated the same as long-term capital gains, and are taxed similarly. Other long-term capital gains may have maximum rates of 25%, or 28% depending on the type of property.

 Specifically, for 2016, this rate only applies if your taxable income is above  for singles or  for married joint-filing couples.

Long-Term Capital Gains Rate Depends on Income

Beginning in 2013, the long-term capital gains rate will depend on income:

Lower Income Threshold for Long-Term Capital Gains Rate
Long-Term
Capital Gains Rate
Single
Head
of
Household
Married
Filing
Jointly
Married
Filing
Separately
2016
0%$0$0$0$0
15%$37,651$50,401$75,301$37,651
20%$415,050$439,001$466,950$233,475
2015
0%$0$0$0$0
15%$37,451$50,201$74,901$37,451
20%$413,201$439,001$464,851$232,426
  • Qualifying widow(er) is the same as Married Filing Jointly.
  • Threshold amounts are indexed for inflation.
 

Additionally taxpayers with income above certain thresholds will also owe the new Net Investment Income Tax (aka Medicare surtax) of 3.8% on all of their investment income, including long-term capital gains:

Income Thresholds for the Net Investment Income Tax
Filing status Threshold Amount
Single, Head of Household$200,000
Married Filing Jointly,
Qualifying Surviving Spouse with Dependent Child
$250,000
Married Filing Separately$125,000
  • Threshold amounts are not indexed for inflation.
  • Both compensation for work, including taxable fringe benefits, and investment income
    are totaled to determine whether the threshold has been reached.

So taxpayers who must pay the higher 20% capital gains rate will also have to pay the 3.8% Medicare surtax, yielding a total tax rate of 23.8% on long-term capital gains. Note that the 3.8% surtax also applies to short-term gains, that, when combined with the new top rate of 39.6%, yields a top tax rate of 43.4%.

To receive the preferential tax treatment for long-term capital gains, the taxpayer must use the Qualified Dividends and Capital Gains Tax Worksheet in the Form 1040 instructions. Any capital asset subject to the 28% rate or unrecaptured §1250 gains, which are subject to a 25% rate, must be calculated using Schedule D Tax Worksheet in the Schedule D instructions.

The amount of qualified dividends or long-term capital gains where the 0% rate applies is equal to the 15% bracket minus the taxpayer's ordinary income. The upper income limit for the 15% tax bracket depends on filing status and is indexed for inflation:

Upper Income Limit for the 15% Tax Bracket
Tax Year Single,
Married
Filing
Separately
Head
of
Household
Married
Filing
Jointly
2016$37,650 $50,400$75,300
2015$37,450$50,200$74,900
2014$36,900$49,400$73,800
2013$36,250$48,600$72,500
2012$35,350$47,350$70,700
2011$34,500$46,250$69,000
  • Qualified surviving spouse is the same as married filing jointly.
  • Married filing separately is one half of the income for married filing jointly.

Children subject to the kiddie tax may not use the 0%, 15%, or 20% tax rate if their parents' applicable rate is higher.

However, higher income taxpayers may still benefit from the 0% rate, if their ordinary income without the qualified dividends or net capital gains is less than the 15% bracket; then the taxpayer can use the 0% rate on that portion of the investment income that is greater than the income from other sources but less than the 15% tax bracket. The 20% bracket is treated similarly.

If any of the following equations ≤ 0, then no gain is taxed at that rate.

Example 1: So if the 15% tax bracket tops out at $34,500, and a single taxpayer has $34,000 of ordinary income plus $6,000 in long-term capital gains, then she can apply the 0% rate applies to $500 of the capital gain while the 15% rate applies to the remaining $5,500, since her $34,000 of ordinary income is less than the 15% tax bracket of $34,500:

If a married couple filing jointly has $59,000 ordinary income and $15,000 of qualified dividends and long-term capital gains, then $10,000 of those investments qualify for the 0% rate and the remaining $5,000 is subject to the 15% rate:

Example 2:

Example 3: Capital Gains Tax as Determined on the Qualified Dividends and Capital Gains Tax Worksheet
Earned income from work$25,000
Short-term gain$5,000
Long-term gain$500,000
Filing StatusSingle
1Taxable Income: Enter taxable income before the application of credits$530,000
2Qualified dividends$10,000
3Enter the smaller of net capital gains or long-term capital gains$500,000
4Net Qualified Gains: Add qualified dividends + capital gains  (Line2 + Line 3)$510,000
5Investment interest expense deduction (Form 4952)$500
6Net qualified gains – interest expense deduction =$509,500
7Line 1 – Line 6 =$20,500
8Enter top of 15% tax bracket for a single person$36,250
9Lesser of taxable income or 15% tax bracket (Line 1 or 8)$36,250
10Smaller of Line7 or Line 9$20,500
11Line 9 – line 10 =$15,750Taxed at 0% rate, so no tax on this amount.
12Smaller of line 1 or line 6$509,500
13Repeat line 11$15,750
14Line 12 – line 13 =$493,750
1539.6% tax bracket$400,000
16Smaller of taxable income or 39.6% tax bracket (Line 1 or 15)$400,000
17Line 7+ line 11 =$36,250
18Line 16 – line 17 =$363,750
19Smaller of line 14 or line 18$363,750Amount taxed at 15%.
20Line 19 × 15% =$54,563Amount of 15% tax.
21Lines 11+19 =$379,500
22Line 12 – line 21 =$130,000Amount taxed at 20%.
23Line 22 × 20% =$26,000Amount of 20% tax.
24Tax on taxable income on Line 7 =$2,633Use either the tax table if less than $100,000 or the Tax Computation Worksheet if greater.
25Add lines 20, 23, and 24$83,196
26Tax on taxable income in line 1 =$167,644
27Tax on all taxable income = smaller of line 25 or line 26 =$83,196
Effective Tax Rate = Total Tax ÷ Taxable Income =15.70%
Example 4: Capital Gains Tax as Determined on the Qualified Dividends and Capital Gains Tax Worksheet
Earned income from work$0
Short-term gain$0
Long-term gain$500,000
1Taxable Income: Enter taxable income before the application of credits$500,000
2Qualified dividends$10,000
3Enter the smaller of net capital gains or long-term capital gains$500,000
4Net Qualified Gains: Add qualified dividends + capital gains (Line2 + Line 3)$510,000
5Investment interest expense deduction (Form 4952)$500
6Net qualified gains – interest expense deduction =$509,500Note that the interest deduction is subtracted from the lower-taxed gain.
7Line 1 – Line 6 =$0
8Enter top of 15% tax bracket for a single person$36,250
9Lesser of taxable income or 15% tax bracket (Line 1 or 8)$36,250
10Smaller of Line7 or Line 9$0
11Line 9 – line 10 =$36,250Taxed at 0% rate, so no tax on this amount.
12Smaller of line 1 or line 6$500,000
13Repeat line 11$36,250
14Line 12 – line 13 =$463,750
1539.6% tax bracket$400,000
16Smaller of taxable income or 39.6% tax bracket (Line 1 or 15)$400,000
17Line 7+ line 11 =$36,250
18Line 16 – line 17 =$363,750
19Smaller of line 14 or line 18$363,750Amount taxed at 15%.
20Line 19 × 15% =$54,563Tax at 15% rate.
21Lines 11+19 =$400,000
22Line 12 – line 21 =$100,000Amount taxed at 20%.
23Line 22 × 20% =$20,000Tax at 20% rate.
24Tax on taxable income on Line 7 =$0Use either the tax table if less than $100,000 or the Tax Computation Worksheet if greater.
25Add lines 20, 23, and 24$74,563
26Tax on taxable income in line 1 =$155,764
27Tax on all taxable income = smaller of line 25 or line 26 =$74,563
Effective Tax Rate = Total Tax ÷ Taxable Income =14.91%

Historical Information

Lower Income Threshold for Long-Term Capital Gains Rate
Long-Term
Capital Gains Rate
Single
Head
of
Household
Married
Filing
Jointly
Married
Filing
Separately
2014
0%$0$0$0$0
15%$36,901$49,401$73,801$36,901
20%$406,751$432,201$457,601$228,801
2013
0%$0$0$0$0
15%$36,251$48,601$72,500$36,251
20%$400,000$425,000$450,000$225,001
  • Qualifying widow(er) is the same as Married Filing Jointly.
  • Threshold amounts are indexed for inflation.