💰Federal Income Tax Accounting Unit 8 – Capital Gains and Losses

What Are Capital Gains and Losses?

• 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) or$80,800 (married filing jointly)
  • The 15% rate applies to taxpayers with taxable income between $40,401 and$445,850 (single) or $80,801 and$501,600 (married filing jointly)
  • The 20% rate applies to taxpayers with taxable income above $445,850 (single) or$501,600 (married filing jointly)
• Net capital losses can offset up to $3,000 of ordinary income per year ($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