💰Federal Income Tax Accounting Unit 8 – Capital Gains and Losses
Capital gains and losses are a crucial aspect of tax accounting, arising from the sale or exchange of capital assets. Understanding how these transactions are classified, calculated, and taxed is essential for effective financial planning and tax management.
This unit covers the types of capital assets, holding periods, calculation methods, and tax treatment of capital gains and losses. It also explores special rules, reporting requirements, and strategies for managing capital gains and losses to optimize tax outcomes.
Capital gains and losses result from the sale or exchange of capital assets
Occur when the selling price of an asset differs from its adjusted basis (original cost plus improvements minus depreciation)
Capital gains arise when the selling price exceeds the adjusted basis, resulting in a profit
Capital losses occur when the selling price is lower than the adjusted basis, resulting in a loss
Gains and losses are classified as either short-term or long-term, depending on the holding period of the asset
Taxed differently than ordinary income, with long-term capital gains generally receiving preferential tax treatment
Can significantly impact an individual's or business's tax liability for the year
Types of Capital Assets
Stocks, bonds, and other investments held for personal or investment purposes
Real estate property, such as land, buildings, and homes, unless used for business purposes
Collectibles, including art, antiques, precious metals, and rare coins
Personal property, such as jewelry, furniture, and vehicles, when sold for a profit
Intangible assets, such as patents, copyrights, and trademarks
Cryptocurrency, like Bitcoin and Ethereum, treated as property for tax purposes
Business assets, such as equipment and machinery, when sold or exchanged
Section 1231 assets, which are business property held for more than one year, may receive special tax treatment
Holding Periods: Short-Term vs. Long-Term
Holding period determines whether a capital gain or loss is considered short-term or long-term
Short-term capital gains and losses result from the sale of assets held for one year or less
Taxed at the same rates as ordinary income, which can be as high as 37% for the highest tax bracket
Long-term capital gains and losses result from the sale of assets held for more than one year
Taxed at preferential rates, typically 0%, 15%, or 20%, depending on the taxpayer's income level
Holding period begins on the day after the asset is acquired and ends on the day the asset is sold or exchanged
Specific identification method allows taxpayers to choose which shares of stock or other securities are sold when they have acquired shares at different times and prices
First-in, first-out (FIFO) method assumes the oldest shares are sold first if no specific identification is made
Calculating Capital Gains and Losses
Capital gain or loss is calculated by subtracting the asset's adjusted basis from its selling price
Adjusted basis is the original cost of the asset, plus any improvements, minus any depreciation or other adjustments
For inherited assets, the basis is generally the fair market value at the time of the decedent's death (stepped-up basis)
For gifted assets, the recipient's basis depends on whether the asset is later sold at a gain or a loss (carryover basis or stepped-down basis)
Selling expenses, such as commissions and fees, are added to the cost basis when calculating the gain or loss
Capital gains and losses are netted against each other, with short-term gains and losses netted first, followed by long-term gains and losses
If there is an overall net capital loss, taxpayers can deduct up to 3,000(1,500 if married filing separately) against ordinary income
Any remaining net capital loss can be carried forward to future tax years indefinitely
Tax Treatment of Capital Gains and Losses
Short-term capital gains are taxed at the same rates as ordinary income, ranging from 10% to 37% depending on the taxpayer's income level
Long-term capital gains are taxed at preferential rates, typically 0%, 15%, or 20%, based on the taxpayer's taxable income and filing status
For 2021, the 0% rate applies to taxpayers with taxable income up to 40,400(single)or80,800 (married filing jointly)
The 15% rate applies to taxpayers with taxable income between 40,401and445,850 (single) or 80,801and501,600 (married filing jointly)
The 20% rate applies to taxpayers with taxable income above 445,850(single)or501,600 (married filing jointly)
Net capital losses can offset up to 3,000ofordinaryincomeperyear(1,500 if married filing separately)
Unused capital losses can be carried forward to future tax years indefinitely
Qualified dividends, which are dividends from domestic corporations and certain foreign corporations, are taxed at the same preferential rates as long-term capital gains
Capital gains may be subject to the Net Investment Income Tax (NIIT), an additional 3.8% tax on investment income for high-income taxpayers
Special Rules and Exceptions
Wash sale rule disallows capital losses if substantially identical securities are purchased within 30 days before or after the sale
Disallowed losses are added to the cost basis of the newly acquired securities
Section 1202 allows for the exclusion of up to 100% of the gain from the sale of qualified small business stock (QSBS) held for more than five years
Section 1031 like-kind exchanges allow for the deferral of capital gains when property held for business or investment purposes is exchanged for similar property
Rules for like-kind exchanges are more restrictive for exchanges completed after December 31, 2017, limiting them to real property only
Gains from the sale of a principal residence may be excluded up to 250,000(500,000 for married couples filing jointly) if certain ownership and use requirements are met
Losses from the sale of personal property, such as a car or furniture, are not deductible unless the property was used for business or investment purposes
Reporting Capital Gains and Losses
Capital gains and losses are reported on Form 8949 and summarized on Schedule D of Form 1040
Form 8949 requires taxpayers to list each capital asset sold or exchanged during the tax year, along with the dates of acquisition and sale, proceeds, cost basis, and gain or loss
Schedule D summarizes the total short-term and long-term capital gains and losses from Form 8949 and other sources
It also calculates the net capital gain or loss and applies the appropriate tax rates
Capital loss carryovers from previous years are also reported on Schedule D
Taxpayers must maintain accurate records of their capital asset transactions, including purchase and sale dates, cost basis, and any adjustments
Failure to report capital gains or accurately calculate the tax liability can result in penalties and interest charges
Strategies for Managing Capital Gains and Losses
Holding assets for more than one year to qualify for preferential long-term capital gains tax rates
Harvesting capital losses by selling assets with unrealized losses to offset capital gains and potentially ordinary income
Be mindful of the wash sale rule when harvesting losses
Donating appreciated assets to qualified charitable organizations to avoid capital gains tax and potentially claim a charitable deduction
Utilizing tax-advantaged accounts, such as 401(k)s and IRAs, to defer or avoid capital gains tax
Investing in tax-efficient mutual funds and exchange-traded funds (ETFs) that minimize turnover and distribute fewer capital gains
Considering installment sales to spread capital gains over multiple tax years
Engaging in tax-loss harvesting near the end of the tax year to offset realized gains and potentially reduce ordinary income
Consulting with a tax professional to develop a personalized strategy based on individual financial goals and tax situation