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.

There are 4 advantages to taxpayers of capital gains taxes over the taxation of income earned from work:

  1. no employment taxes are assessed on capital gains, except for the Medicare surcharge of 3.8% for higher income taxpayers;
  2. the maximum tax rate on long-term capital gains, which is property held longer than 1 year, equals lower of the taxpayer's marginal rate or the long-term capital gains rate, which is 20% for many assets, including stocks and bonds and other financial instruments, although there may be a 3.8% Medicare surcharge for higher income taxpayers;
  3. gains are not taxed until they are realized, i.e., when the property is sold; in some cases, such as with real estate, taxes can be deferred even further through tax-free exchanges of property; and
  4. capital gains may escape taxation completely if the property is bequeathed to heirs, because the tax basis of the property, which is subtracted from the sales price of the property to determine the gain, is stepped-up in basis to its value when the death occurred (of course, if the property loses value, then its value is stepped down)

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
Collectibles 28%
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% or 37%,
then the marginal capital gain rate within that bracket is:
20%
 If regular tax rate on ordinary income exceeds 15%, but is less than 37%,
then the marginal capital gain rate within these brackets is:

15%
 If regular tax rate on ordinary income is 15% or less,
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.

The new Republican tax policy, passed at the end of 2017, known as the Tax Cuts and Jobs Act, has changed the tax brackets for 2018 and afterwards, but the qualified dividend rate of 0% still applies to lowest 2 income tax brackets, which under the new law is the 10% and 12% brackets. The income threshold for the 20% bracket, which corresponds to the new tax bracket of 37%, has also increased, so it applies to minimum incomes of $500,000 for single and head of household, and $600,000 for married filing jointly.

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
2018
0% $0 $0 $0 $0
15% $38,600 $51,700 $77,200 $38,600
20% $500,000 $500,000 $600,000 $300,000
2017
0% $0 $0 $0 $0
15% $37,950 $50,800 $75,900 $37,950
20% $415,050 $439,001 $466,950 $233,475
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 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. Note, that, starting for tax year 2018, the tax brackets have changed, so the 0% rate will apply to the 12% bracket or lower. The upper income limit for these brackets depends on filing status and is indexed for inflation:

Upper Income Limit for the 0% Rate on Qualified Dividends
Tax Year Single,
Married
Filing
Separately
Head
of
Household
Married
Filing
Jointly
2018 $38,600 $51,700 $77,200
2017 $37,950 $50,800 $75,900
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.

Examples: Calculating the Capital Gains Tax on Qualified Dividends for Tax Year 2017

Example 1: Single
Given Facts
Filing Status Single
Tax Year 2017
Ordinary Income $34,000
Long-Term Capital Gains $6,000
Calculations
Top Taxable Income Qualifying for the 0% Capital Gains Rate $37,950
  • = Top Income Subject to 0% Rate – Ordinary Income
  • Gain qualifying for the 0% rate
$3,950
Gain qualifying for the 15% rate $2,050
Capital Gains Rate 15%
Capital Gains Tax $308
Example 2: Married Filing Jointly
Given Facts
Filing Status Married filing jointly
Tax Year 2017
Ordinary Income $70,000
Long-Term Capital Gains $15,000
Calculations
Top Taxable Income Qualifying for the 0% Capital Gains Rate $75,900
  • = Top Income Subject to 0% Rate – Ordinary Income
  • Gain qualifying for the 0% rate
$5,900
Gain qualifying for the 15% rate $9,100
Capital Gains Rate 15%
Capital Gains Tax $1,365
Example 3: High Income Taxpayer
Given Facts
Filing Status Single
Tax Year 2017
Ordinary Income $12,000
Long-Term Capital Gain + Qualified Dividends $700,000
Calculations
Maximum Income Subject to 15% Capital Gains Rate $415,050
Top Ordinary Income Qualifying for the 0% Rate $36,250
  • = Top Income Subject to 0% Rate – Ordinary Income
  • Gain qualifying for the 0% rate
$24,250
Tax on 0% amount $0
Top Income Subject to the 15% Rate $415,050
Amount Taxed at 15%
= Top Income Subject to 15% – Top Income Subject to 0%
$378,800
Tax on the amount subject to the 15% rate $56,820.00
Amount Taxed at 20%
= Income Subject to 20% – Top Income Subject to 15%
$284,950
Tax on the amount subject to the 20% rate $56,990.00
Total Long-Term Capital Gains Tax
= 15% + 20% amounts
$113,810.00

Historical Information and Examples

Here are 2 examples of figuring the capital gains tax using worksheets provided by the IRS. These examples are for the 2013 tax year, but the calculation method remains the same for the current tax year.

Example 3: Capital Gains Tax as Determined on the Qualified Dividends and Capital Gains Tax Worksheet (based on the 2013 tax year)
Earned income from work $25,000
Short-term gain $5,000
Long-term gain $500,000
Filing Status Single
1 Taxable Income: Enter taxable income before the application of credits $530,000
2 Qualified dividends $10,000
3 Enter the smaller of net capital gains or long-term capital gains $500,000
4 Net Qualified Gains: Add qualified dividends + capital gains  (Line2 + Line 3) $510,000
5 Investment interest expense deduction (Form 4952) $500
6 Net qualified gains – interest expense deduction = $509,500
7 Line 1 – Line 6 = $20,500
8 Enter top of 15% tax bracket for a single person $36,250
9 Lesser of taxable income or 15% tax bracket (Line 1 or 8) $36,250
10 Smaller of Line7 or Line 9 $20,500
11 Line 9 – line 10 = $15,750 Taxed at 0% rate, so no tax on this amount.
12 Smaller of line 1 or line 6 $509,500
13 Repeat line 11 $15,750
14 Line 12 – line 13 = $493,750
15 39.6% tax bracket $400,000
16 Smaller of taxable income or 39.6% tax bracket (Line 1 or 15) $400,000
17 Line 7+ line 11 = $36,250
18 Line 16 – line 17 = $363,750
19 Smaller of line 14 or line 18 $363,750 Amount taxed at 15%.
20 Line 19 × 15% = $54,563 Amount of 15% tax.
21 Lines 11+19 = $379,500
22 Line 12 – line 21 = $130,000 Amount taxed at 20%.
23 Line 22 × 20% = $26,000 Amount of 20% tax.
24 Tax on taxable income on Line 7 = $2,633 Use either the tax table if less than $100,000 or the Tax Computation Worksheet if greater.
25 Add lines 20, 23, and 24 $83,196
26 Tax on taxable income in line 1 = $167,644
27 Tax 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
1 Taxable Income: Enter taxable income before the application of credits $500,000
2 Qualified dividends $10,000
3 Enter the smaller of net capital gains or long-term capital gains $500,000
4 Net Qualified Gains: Add qualified dividends + capital gains (Line2 + Line 3) $510,000
5 Investment interest expense deduction (Form 4952) $500
6 Net qualified gains – interest expense deduction = $509,500 Note that the interest deduction is subtracted from the lower-taxed gain.
7 Line 1 – Line 6 = $0
8 Enter top of 15% tax bracket for a single person $36,250
9 Lesser of taxable income or 15% tax bracket (Line 1 or 8) $36,250
10 Smaller of Line7 or Line 9 $0
11 Line 9 – line 10 = $36,250 Taxed at 0% rate, so no tax on this amount.
12 Smaller of line 1 or line 6 $500,000
13 Repeat line 11 $36,250
14 Line 12 – line 13 = $463,750
15 39.6% tax bracket $400,000
16 Smaller of taxable income or 39.6% tax bracket (Line 1 or 15) $400,000
17 Line 7+ line 11 = $36,250
18 Line 16 – line 17 = $363,750
19 Smaller of line 14 or line 18 $363,750 Amount taxed at 15%.
20 Line 19 × 15% = $54,563 Tax at 15% rate.
21 Lines 11+19 = $400,000
22 Line 12 – line 21 = $100,000 Amount taxed at 20%.
23 Line 22 × 20% = $20,000 Tax at 20% rate.
24 Tax on taxable income on Line 7 = $0 Use either the tax table if less than $100,000 or the Tax Computation Worksheet if greater.
25 Add lines 20, 23, and 24 $74,563
26 Tax on taxable income in line 1 = $155,764
27 Tax on all taxable income = smaller of line 25 or line 26 = $74,563
Effective Tax Rate = Total Tax ÷ Taxable Income = 14.91%
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.