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Whenever property is disposed of, such as in a sale, the seller may realize a taxable net capital gain or 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.
Recognized gain is the amount of realized gain that is includable in the taxpayers gross income; recognized loss is the amount of realized lost that is deductible.
Realized gains or losses are not recognized for nontaxable exchanges; 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. 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 $17,000, you will have a recognized gain of $2,000. By contrast, a tax-free transaction is never recognized.
Special rules, which are not discussed in this article, 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.
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.
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 tax rate for collectibles is 28% regardless of how long the property has been held.
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
If the property was held for one year or less, then this disposition is considered to be an ordinary income or loss. If the property was held longer, then it is considered to be a capital gain or loss, which usually receives better tax treatment.
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 offset any capital gains, including from other personal property. When offsetting other income, short-term losses must first be used, then long-term losses.
When there is a combination of capital gains or losses, the gains or losses must be segregated into their respective holding period categories, either short-term or long-term, where the capital losses reduce the capital gains within the respective category. If there is still a net capital gain in one category and a net capital loss in the other, then the capital loss can be used offset the capital gain. If a capital loss is greater than the capital gain, the loss may be used to offset up to $3,000 of other income. For married couples filing separately, capital losses can only offset up to $1,500 of each spouse's income. However, a spouse can only offset her own income with her own losses. In a joint filing, the $3,000 limit applies and the gains and losses of both spouses can be combined.
Any unused portion can be carried forward indefinitely. However, losses carried forward retains its time character, so a short term loss carried forward is a short term loss; likewise, for long-term losses. The taxpayer should keep records of any capital losses that are carried forward.
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 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.
Capital gains and losses must also be segregated into the separate types of capital assets recognized by tax law. Losses must first be used to offset capital gains within the respective category. However, if there is still a capital loss, then it can be applied to other categories. So if you have a long term loss in stock transactions, the loss can be used to offset capital gains on collectibles even though the tax rates are different.
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 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 REITs, 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.
Generally, capital losses are not allowed on dispositions of property between related parties, which includes ancestors and descendents, and siblings, whether whole or half blood. Losses are generally also disallowed between taxpayers and other legal entities which 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.
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.
Long-term capital gains may qualify for preferential tax rates of either 0% or 15%, for 2011 and 2012, depending on the top marginal tax rate for the taxpayer. For taxpayers whose income is in the 15% bracket or lower, the the 0% rate applies; otherwise, the 15% rate applies. The same rates are also applied to qualified dividends, which are treated the same as long-term capital gains or losses, and are taxed similarly. Other long-term capital gains may have maximum rates of 25%, or 28% depending on the type of property.
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 must be calculated using Schedule D Tax Worksheet in the Schedule D instructions. Section 1250 gains are subject to a 25% rate.
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 for 2011 depends on filing status:
Children subject to the kiddie tax may not use the 0% or 15% 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 0% investment income that is greater than the income from other sources but less than the 15% tax bracket.
If Ordinary Income < 15% Bracket, then:
So if 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 $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: