2008 Capital Gains

A taxpayer in the 10% or 15% income tax bracket will not have to pay tax on a net capital gain–a technical term defined as net long-term capital gain in excess of net short-term capital loss–realized in 2008, 2009, or 2010. In particular, a net capital gain will be taxed at a 0% rate for a taxpayer in the 10% or 15% income tax bracket in 2008, 2009, or 2010. But a taxpayer in the 25%, 28%, 33%, or 35% income tax bracket will continue to pay tax at a 15% rate on a net capital gain realized during these years. Click on for a full discussion of income tax brackets and for more information on the concept of net capital gain.

Other capital gains tax rates will not change in 2008. Specifically, a gain on the sale of a collectible or qualified small business stock (Section 1202 stock) will continue to be treated as an item of ordinary income for a taxpayer in the 10%, 15%, 25%, or 28% income tax bracket; but the maximum tax rate on a gain from the sale of a collectible or Section 1202 stock is 28% even if a taxpayer is in a higher income tax bracket (i.e., the 33% or 35% income tax bracket). The regular tax rate also applies in 2008 to recapture of depreciation taken on Section 1250 property for a taxpayer in the 10%, 15%, or 25% income tax bracket; at the same time, the maximum tax rate on Section 1250 recapture is 25% even if a taxpayer is in a higher income tax bracket (viz., the 28%, 33%, or 35% income tax bracket). Additional relevant articles on 2008 capital gains tax rates are listed below:

Many happy returns, Roger

Capital Gains Tax Rate

A taxpayer should know that if she were to realize a gain on the sale of a long-term capital asset–a capital property held for more than one year, she would be taxed but at a rate lower than that for an item of ordinary income. In contrast, a gain on the sale of a short-term capital asset–a capital property held for one year or less–would be taxed as if it were an item of ordinary income. The distinction between the tax treatment for a capital asset with a long-term holding period and that for a capital asset with a short-term holding period is the key theme of this article. (For a full discussion of how holding period affects the classification of a capital asset, click on my earlier post on this topic, .)

The reader should also know that the deduction from ordinary income for a net capital loss–a situation in which taxpayer’s capital losses for the year are greater than his capital gains–is limited to $3,000 annually. (I use the term “bonus write-off” to describe this deduction from ordinary income.) In particular, the rule is that a taxpayer is allowed to deduct up to $3,000 of this loss annually; but a taxpayer has the option to carry forward any remaining capital loss–the capital loss that remains after subtracting the $3,000 bonus write-off amount–to future tax years. (To avoid needless repetition, when I mention a capital loss carryforward in the remainder of the article, it is net of the $3,000 bonus write-off amount.) In any event, capital losses are deductible in full against capital gains; the $3,000 limit applies only if a taxpayer has a net capital loss for the year.

Capital gains and losses are reported on Schedule D (Capital Gains and Losses) of Form 1040, but the authors of a popular textbook remark that even the Internal Revenue Service admits “the form could be correctly filled out without the taxpayer understanding what was going on.” Daniel Posin & Donald Tobin, Principles of Federal Income Taxation 253 n. 265 (Concise Hornbook Series, 7th ed., West 2005). As one purpose of this web log is to help readers understand the inner workings of the Internal Revenue Code, I will provide a concise introduction to the logic behind the calculation of capital gains and losses. (Note: Click on the Tax Forms page on the navigation menu above to see a copy of Schedule D.)

Before I outline the netting process for sales of capital assets, the reader should note that the complexity of this article is due in large part to the fact that net short-term capital gain is taxed at ordinary income rates and net capital gain at the more favorable capital gains rates. In the federal income tax law, net capital gain is defined as net long-term capital gain in excess of net short-term capital loss. Net capital loss is the excess of capital losses over capital gains. An added complication is that capital gains rates vary according to income tax brackets, that is, taxpayers in higher income tax brackets will pay capital gains taxes at higher rates than those in lower brackets. Finally, transactions involving certain categories of capital assets–for example, collectibles, qualified small business stock (Section 1202 stock), and depreciation recapture on Section 1250 assets–may be taxed at higher rates than transactions involving other types of capital assets.

The first step in determining net capital gain or loss for the year is to separate sales of capital assets into sales of short-term capital assets and sales of long-term capital assets. After an individual works through a complicated netting process that (1) uses short-term capital losses to offset short-term capital gains and long-term capital losses to offset long-term capital gains and (2) compares net long-term capital gain with net short-term capital loss, any resulting net capital gain is taxed at the applicable capital gains rate. If the result of this process is a net capital loss, then $3,000 of this loss may be used to offset ordinary income and any remainder can be carried forward to future tax years.

Sales of Short-Term Capital Assets
Short-term capital gains for the year are compared with short-term capital losses; if the result of this netting process is a net short-term capital gain, then this amount is treated as an item of ordinary income and taxed at regular rates. On the other hand, if the result is a net short-term capital loss and the taxpayer doesn’t sell any long-term capital assets during the year, he may deduct up to $3,000 of this net capital loss and carry forward the remainder.

Sales of Long-Term Capital Assets
Long-term capital gains for the year are compared with long-term capital losses. If the result of this netting process is a net long-term capital gain and the taxpayer doesn’t have an offsetting net short-term capital loss, then this amount is, by definition, a net capital gain that will be taxed at the applicable capital gains rate. Likewise, if the taxpayer has a net long-term capital gain and a net short-term capital loss for the year, then the net short-term capital loss is subtracted from the net long-term capital gain. If the result is positive, the taxpayer has a net capital gain for the year. If, on the other hand, the result of this calculation is negative, that is, if net short-term capital loss exceeds net long-term capital gain, the taxpayer has a net capital loss and may deduct up to $3,000 of this loss in the current year and carry forward the remainder. In addition, if the taxpayer has only a net long-term capital loss for the year, the taxpayer may also deduct up to $3,000 of this net capital loss in the current year and, again, carry forward the remainder.

To repeat, there are four possible outcomes to the netting process for sales of capital assets:

  1. A net short-term capital gain and a net long-term capital gain. In this case, the net long-term capital gain is taxed at taxpayer’s capital gains rate and the net short-term capital gain at taxpayer’s ordinary income rate.
  2. A net short-term capital loss and a net long-term capital loss. In this situation, the losses are combined and used to offset up to $3,000 of ordinary income; any excess net capital loss may be carried forward indefinitely.
  3. A net long-term capital gain and a net short-term capital loss. If after offsetting the two categories the result is a net capital gain, then this amount is taxed at taxpayer’s capital gains rate. On the other hand, if the result is a net capital loss, then up to $3,000 of this loss can be taken as a deduction against ordinary income in the current year with unlimited carryforward of any remaining loss amount.
  4. A net short-term capital gain and a net long-term capital loss. If after offsetting the two categories the result is a net short-term capital gain, then this amount is taxed at taxpayer’s ordinary income rate. If the result is a net capital loss, then up to $3,000 of this loss may be deducted from ordinary income with unlimited carryforward of any remaining loss.

Capital Gains Tax Rates
In 2007, net capital gain is taxed at a 5% rate for a taxpayer in the 10% or 15% income tax bracket. For a taxpayer in the 25%, 28%, 33%, or 35% income tax bracket, the tax rate on a net capital gain is 15%. (For an explanation of the concept of income tax brackets, click on my earlier article, .) Notice, however, that the regular income tax rate will apply to a gain on the sale of a collectible or qualified small business stock (Section 1202 stock) for a taxpayer in the 10%, 15%, 25%, or 28% income tax bracket; but the maximum tax rate on a gain from the sale of a collectible or Section 1202 stock is 28% even if a taxpayer is in a higher income tax bracket (i.e., the 33% or 35% income tax bracket). The regular tax rate also applies to recapture of depreciation taken on Section 1250 property for a taxpayer in the 10%, 15%, or 25% income tax bracket; at the same time, the maximum tax rate on Section 1250 recapture is 25% even if a taxpayer is in a higher income tax bracket (viz., the 28%, 33%, or 35% income tax bracket). For a convenient summary of rates on capital gains, click on . For help in deciphering the tax plans of the 2008 presidential candidates, click on .

Supplementary relevant articles on tax rates for capital gains are listed below:

Many happy returns, Roger

Holding Period

The rate at which a capital asset is taxed depends on the holding period–the length of time a taxpayer holds a capital asset. For example, a sale at a price other than basis of a long-term capital asset–a capital property that is held for more than one year–will generate a long-term gain or loss. On the other hand, a comparable sale of a short-term capital asset–a capital property that is held for one year or less–will produce a short-term gain or loss. The classification is not trivial: a gain on the sale of a long-term capital asset is taxed at a lower rate than a gain on the sale of a short-term capital asset.

For a capital asset, the day of acquisition is excluded but the day of disposal is included in the holding period calculation. In short, the day after acquisition marks the beginning of the holding period, the number of days in a month doesn’t matter, and capital property acquired on the last day of the month must be held until the first day of the thirteenth month after acquisition to qualify for long-term gain or loss treatment.

Example 1: A capital asset acquired on February 28, 2009 by Mr. Smith must be held until March 1, 2010 or later for a sale or exchange of such asset to qualify for long-term capital gain or loss treatment. If Smith were to sell this asset at a price other than basis on February 28, 2010, he would have a short-term capital gain or loss.

Example 2: A capital asset acquired on March 31, 2008 must be held until April 1, 2009 or later to qualify for long-term capital gain or loss treatment.

More generally, if a taxpayer takes a substituted basis in a capital asset (i.e., taxpayer takes seller’s or transferor’s basis in the property), then the time the property is held is tacked on to the seller’s or transferor’s holding period. To complicate matters, special rules apply to property acquired by conversion or tax-free exchange, gift, or inheritance.

Property Acquired by Conversion or Tax-Free Exchange
The holding period of a capital asset acquired by conversion, voluntary or involuntary, or tax-free exchange will include transferor’s holding period if transferee’s basis in the property is the same as transferor’s basis on the date of transfer.

Property Acquired by Gift
The holding period of a capital asset acquired by gift will include the holding period of the donor if, on the date of the gift, donee’s basis in the property is the same as donor’s basis. If, however, the fair market value (FMV) of the property is less than donor’s adjusted basis and the donee sells the property at a loss, then the holding period begins on the date of the gift and donee’s basis for determining loss is the property’s FMV.

Example 3: Smith acquires by gift a capital asset with a FMV of $25,000 and adjusted basis of $20,000 on October 15, 2008. The donor purchased the property on September 30, 2004, and Smith takes a substituted basis in the property. Since Smith’s basis is the same as donor’s basis on the date of the gift, Smith inherits donor’s holding period. If Smith were to sell the property for $25,000 on December 14, 2008, the transaction would qualify for long-term capital gain treatment.

Example 4: Smith acquires by gift a capital asset with a FMV of $15,000 and adjusted basis of $30,000 on March 15, 2008. The donor purchased the property on January 3, 2005. If Smith were to sell the property for $10,000 on November 1, 2008, Smith’s holding period would start on the date of the gift and his basis for determining loss would be $15,000, the FMV of the property at the time of the gift.

Property Acquired by Inheritance
The sale or exchange of a capital asset acquired by inheritance will produce a long-term gain or loss regardless of how long the legatee holds the property.

Additional relevant articles on the topic of holding period for a capital asset are listed below:

Many happy returns, Roger

← Previous Page — Next Page →