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 Capital Gains Tax, or CGT, is owed on any type of property you sell for more than paid for it - almost. To be more accurate, we first need to completely understand what a capital asset is, then figure out the cost basis for the asset. The cost basis or simply "basis" is usually what you paid for the asset, adjusted for money you may have spent fixing it up. But before we go too far down that road, let's revisit the concept of a capital asset.
Gains on Capital Assets
Nearly everything a person owns for their own personal use, or investments they might have, are considered capital assets. Familiar examples of capital assets include your home, cars, furniture, and shares of stock and bonds that are held in a personal account.
When you sell a capital asset for more than you paid for it, you have a capital gain. If you sell the asset for less than you paid for it, you have a capital loss. But there are some pretty important exceptions to these rules that we will talk about later such as inherited property, cars, and homes.
Adjusting Cost Basis
Before you figure out if you've had a loss or gain on a sale of property, you can usually make certain adjustments to the cost basis of the property. Typically, this would include any improvement that is expected to last for more than 1 year. Examples of such improvements on a home that would be considered increases to basis include:
- New Sidewalks, roads, water connections, or similar external infrastructure improvements.
- Enhancements to your home such as the installation of central air conditioning.
- Additions to an existing home, or structural improvements, such as replacing the entire roof of a home or a bathroom addition.
These types of improvements to a capital asset such as a home are long-term investments in the home itself. As such, they add to the value of the home and the cost basis can be increased by the amounts spent on these improvements.
Long and Short Term Capital Gains
There are two types of capital gains and losses - long-term and short-term. If you own the asset for more than one year before you sell it then your capital gain or loss is considered long-term. If you hold onto the asset for one year or less, then your capital gain or loss is considered short-term.
The rate at which capital gains are taxed is determined by whether or not you have net capital gain. A net capital gain is the amount by which all your long-term capital gains exceed any short-term capital losses. The highest tax rate on a net capital gain is normally 15%, however there are three important exceptions to this rule including:
- Any net capital gains from selling Section 1250 real property - due to depreciation - is taxes at a maximum 25% rate.
- Any taxable gain from qualified small business stock is taxed at a maximum 28% rate.
- Gains from selling collectibles, such as art or coins, are taxed at a maximum 28% rate.
If you experience a capital loss, then the loss can be claimed up to a maximum of $3,000, or $1,500 if married filing separately. If your losses exceed these maximums, you are allowed to carry the loss forward into later years for tax reporting purposes.
Capital Losses on Personal Use Property
Personal-use property such as cars, homes and boats are not subject to capital losses. If you buy a car for $30,000 and sell it four years later for $10,000, you cannot claim a capital loss on the car. The same holds true for other personal use property such as a boat or even your home.
Gains and Losses on Stocks and Bonds
The cost basis of stocks and bonds is normally the purchase price of the security plus any costs or fees associated with the purchase such as brokerage commissions. If you acquire capital assets such as stocks or bonds by any other means - such as through a gift or inheritance - then your cost basis is usually the fair market value or the previous owner's adjusted basis.
Inherited Property and Capital Gains Tax
If you do not have to file a federal estate tax return, then your basis in the inherited property is its appraised value on the date of passing for state inheritance or transmission taxes. Otherwise the property inherited from a descendent usually has its value or basis determined in one of the following four ways:
- The appraised fair market value as of the date of passing.
- The fair market value on the alternate valuation date if a personal representative of the estate chooses to use alternate valuation.
- A special-use valuation method for real property used in farming or a closely held business if chosen for estate tax purposes.
- When the land that is part of the decedent's estate is a qualified conservation easement, then it may qualify for an adjusted cost basis.
You can find more detailed information on alternate valuation dates and qualified conservation easements in the IRS Form 706.
Recent Changes to Capital Gains Tax
Starting back in 2003, the long-term capital gain tax rate was reduced to 15% or 5% for individuals in the lowest two federal income tax brackets. Short-term capital gains are taxed at an individual's "normal" incremental tax rate. The approved changes to capital gains tax law has a sunset provision and it scheduled to revert back to the rates - around 20% - that were in effect prior to 2003.
Other recent changes to tax law provisions dealing with capital gains include:
- In the years 2008, 2009, and 2010 individuals in the 10% and 15% tax brackets will pay 0% on gains from eligible dividends and some capital gains.
- A 15% tax rate on dividend and capital gains that was scheduled to expire in 2008 was modified by President Bush in May 2006 and now extends through 2010.
- In 2010 and beyond, the qualified 5-year 18% capital gains tax rate will be reinstated.
- After 2010, all dividends will be taxed at the standard income tax rate, regardless of the tax bracket in which the taxpayer falls. Other longer-term capital gains will revert back to the 20% level or for individuals in the 15% tax bracket the capital gains tax will stand at 10%.
Important Exclusions from Capital Gains Tax
There are several very important exclusions from capital gains tax that are worth reviewing. First off, an individual can exclude up to $250,000, and married couples filing jointly $500,000, of any capital gains realized on the sale of a home or what is known as real property. This exclusion applies if the property is used as the primary residence for at least two out of the prior five years.
In addition, if an individual realizes both a capital gain and a capital loss in the same tax year, then the loss can be used to cancel out a gain. This is one of the reasons many investors sell their investments at year's end that have lost value - to help them offset capital losses on other investments.
Finally, the tax law allows individuals to defer their capital gains tax during a 1031 exchange of property, during an installment sale, or when their involved in the formation of a charitable trust. These particular matters are best discussed with an attorney familiar with the intricacies of tax law.
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