Capital Gains and Losses and Your Taxes

If you own taxable investment accounts, real estate, collectibles, or literally any item that can appreciate or depreciate in value, you’ve likely had to deal with capital gains or losses on your tax return.  (Actually, only if you’ve sold the item.)  But how much do you really know about capital gains and losses?  The IRS has published Tax Tip 2010-35 listing 10 Facts About Capital Gains and Losses – detailing what the IRS deems important about gains and losses and how they could effect your tax situation.  Following below the IRS’ list is some additional detail on treatment of capital gains and losses.

10 Facts About Capital Gains and Losses

1. Almost everything you own and use for personal purposes, pleasure or investment is a capital asset.
2. When you sell a capital asset, the difference between the amount you sell it for and your basis – which is usually what you paid for it – is a capital gain or a capital loss.
3. You must report all capital gains on your income tax return.
4. You may deduct capital losses only on investment property, not on property held for personal use.
5. Capital gains and losses are classified as long-term or short term, depending on how long you hold the property before you sell it.  If you hold it more than one year, your capital gain or loss is long-term.  If you hold it one year or less, your capital gain or loss is short-term.
6. If you have long-term gains in excess of your long-term losses, you have a net capital gain to the extent your net long-term capital gain is more than your net short-term capital loss, if any.
7. The tax rates that apply to net long-term capital gains are generally lower than the tax rates that apply to other income.  For 2010, the maximum long-term capital gains rate for most people is 15%.  For lower-income individuals, the rate may be 0% on some or all of the net capital gain.  Special types of net capital gain can be taxed at 25% or 28%.
8. If your capital losses exceed your capital gains, the excess loss can be deducted on your tax return and used to reduce other income, such as wages, up to an annual limit of $3,000, or $1,500 if you are married filing separately.
9. If your total net capital loss is more than the yearly limit on capital loss deductions, you can carry over the unused part to the next year and treat it as if you incurred it in that year.
10. Capital gains and losses are reported on Schedule D, Capital Gains and Losses, and then transferred to line 13 of Form 1040.

Calculations

To determine tax treatment, your short-term capital gains (STCG) and short-term capital losses (STCL) are “netted”, and the same is done with your long-term capital gains (LTCG) and long-term capital losses (LTCL), as in the following equations:

STCG – STCL = Net STCG(or L)

LTCG – LTCL = Net LTCG(or L)

If the amount of loss (in either equation) is greater than then amount of gain, you have a net capital loss (either short or long).  Likewise if the amount of gain is greater than the amount of loss, you have a net capital gain.  These amounts are then netted against each other, as follows:

Net Capital Gains = Net STCG(or L) + Net LTCG(or L)

Tax Treatment Situations

If you have only short-term gains and losses, any net gain will be taxed at your ordinary income tax rate – that is, it is added to your other income from wages and the like, taxed just the same as income.  A net loss can be deducted from your income to the extent of the $3,000 annual limit discussed previously.  Any remaining net loss can be carried over to future years and deducted against net capital gains first, and then at the $3,000-per-year rate against your ordinary income until the net loss is exhausted.

Likewise, if you have both short-term and long-term gains and losses and the net short-term gains are greater than any net long-term losses, the remaining difference is taxed and treated as ordinary income.

If you have only long-term gains and losses, any net gain will be taxed at the applicable long-term capital gains rates (typically 0% or 15% through 2012).  Any net loss is treated the same as the net short-term capital loss described above.

If you have net long-term gains and net short-term losses that are less than or equal to the net long-term gains, in the “netting” discussed above, your net long-term gains will be reduced to the extent of your net short-term losses.

If the nettings result in net capital gains for both long-term and short-term, your net short-term gains will again be taxed at your ordinary income tax rate, but the net long-term gains will be taxed at the applicable long-term capital gains rate (typically either 0% or 15% through 2012).

And lastly, if the nettings result in net capital losses for both holding periods, this net loss is (as you might expect) allowed to be deducted from ordinary income at the $3,000-per-year rate.  Any amount of loss that remains is carried over to future years (as described previously).

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