Unit
- Capital gains tax: A levy on profits from the sale of capital assets such as stocks, bonds, real estate, and collectibles. The tax applies to the difference between the sale price and the adjusted cost basis, excluding transaction costs.
- Capital asset: Almost everything you own and use for personal purposes, investment, or business is a capital asset. Examples include your home, car, securities, and business equipment. The IRS defines capital assets broadly but excludes certain items like inventory and accounts receivable.
- Realized vs. unrealized gains: A gain is realized when an asset is sold, exchanged, or otherwise disposed of. Unrealized gains are paper profits that are not subject to tax until the transaction is complete. Holding assets does not trigger capital gains tax.
- Short-term vs. long-term: The holding period determines the tax rate. Assets held for one year or less generate short-term gains taxed as ordinary income. Assets held longer than one year qualify for lower long-term capital gains rates, which range from 0% to 20% depending on taxable income.
- Taxable event triggers: Sales, exchanges, transfers, gifts (in some cases), and involuntary conversions like casualty or theft can trigger capital gains tax. Gifts to charity or spouses may be partially or fully exempt.
- Non-taxable events: Like-kind exchanges under Section 1031 for real estate, rollovers into retirement accounts, and transfers at death (with step-up in basis) can defer or eliminate capital gains tax. Knowing these exceptions is critical for planning.
- Capital loss offset: Capital losses can offset capital gains dollar for dollar. If losses exceed gains, up to $3,000 ($1,500 if married filing separately) of net loss can offset ordinary income each year, with unused losses carried forward indefinitely.
- Wash sale rule: If you sell a security at a loss and buy a substantially identical security within 30 days before or after the sale, the loss is disallowed for tax purposes. The disallowed loss is added to the basis of the new shares, deferring the deduction.
- Adjusted basis: The cost basis of an asset can be increased by capital improvements and decreased by depreciation or return of capital. Properly tracking adjustments is essential for calculating accurate gain or loss. Examples include adding a room to a home or claiming depreciation on rental property. Incorrect basis often leads to overpaying or underpaying tax.
- Net investment income tax: High income taxpayers may owe an additional 3.8% tax on net investment income, including capital gains, if modified adjusted gross income exceeds certain thresholds. This surtax applies to individuals with MAGI over $200,000 ($250,000 married filing jointly). It is separate from regular capital gains tax.
- Primary residence exclusion: Under Section 121, single filers can exclude up to $250,000 of capital gain from the sale of a principal residence, and married couples filing jointly can exclude up to $500,000. To qualify, you must have owned and used the home as your main residence for at least two of the five years before sale.
Financial Formula
Capital Gain/Loss
Gain or Loss = Sale Proceeds - Adjusted Cost Basis
Gain or Loss = Sale Proceeds - Adjusted Cost Basis
Where:
- Sale Proceeds: Total amount received from the sale, including cash, fair market value of property received, and any liabilities assumed by the buyer.
- Adjusted Cost Basis: Original purchase price plus improvements, commissions, and fees, minus any depreciation or return of capital.
- Result: Positive value indicates a gain; negative indicates a loss.
Quick Revision
- Capital gains tax applies to profits from selling capital assets.
- Holding period classifies gains as short-term (ordinary rates) or long-term (preferential rates).
- Realization triggers the tax; unrealized gains are not taxed.
- Losses offset gains and can reduce ordinary income up to $3,000 annually.
- The wash sale rule prevents tax-motivated loss recognition on substantially identical securities.