Capital Gains Tax (CGT)

Generally, capital gains tax, or CGT, is owed on any property sold for a profit.  Accurately determining a capital gain involves both an understanding of its cost basis, which is the amount of money paid for the asset, as well as any dollars spent on improvements.

In this article, we're going to discuss capital gains tax. That discussion will start with a definition of a capital asset, how to determine its cost basis, and the difference between long and short term gains.  Then we'll finish up with some of the changes outlined in the American Taxpayer Relief Act of 2012.

Gains on Capital Assets

Nearly every item an individual possesses for their personal use, or investments they might own, is considered a capital asset.  Familiar examples include a home, cars, furniture, and shares of stocks and bonds that are held in a personal account.

When an individual sells a capital asset for more than they paid for it, they have a capital gain.  If an individual sells the asset for less than they paid for it, they have a capital loss.  But there are some very important exceptions to these rules that are discussed later on.  This includes assets such as inherited property, cars, and homes.

Determining Cost Basis

Before figuring out if there was a loss or gain on a sale of property, it's necessary to make certain adjustments to its cost basis.  Typically, this would include the cost of any improvement that is expected to last for more than one year.  Examples of such improvements would include:

  • New sidewalks, roads, water connections, or similar external infrastructure improvements.
  • Enhancements to a 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 are long-term investments in the home.  As such, they add to its value, and the home's 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 an asset is owned for more than one year before it's sold, the capital gain or loss is considered long-term.  The gain or loss on assets held for twelve months or less are considered short-term.

A net capital gain is the amount by which all the long-term capital gains exceed any-short term capital losses.  The ATRA raised the highest tax rate on a net capital gain to 20% in 2013; however, there are three important exceptions to this rule that remained unchanged:

  • Any net capital gains from selling Section 1250 real property, due to depreciation, is taxed 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 an individual experiences a capital loss, it can be claimed up to a maximum of $3,000, or $1,500 if married, filing separately.  If the loss exceeds these maximums, it can be carried 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 someone buys a car for $30,000, and sells it four years later for $10,000, they cannot claim a capital loss on the car.  The same holds true for other personal use property such as a boat or even a 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 someone acquires capital assets such as stocks or bonds by any other means, such as through a gift or inheritance, the cost basis is usually the fair market value at the time of transfer, or the previous owner's adjusted basis.

Inherited Property and Capital Gains Tax

If an heir is not required to file a federal estate tax return, their basis for 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 descendant's estate is a qualified conservation easement, then it may qualify for an adjusted cost basis.

More detailed information on alternate valuation dates and qualified conservation easements can be found in IRS Form 706.

Recent Changes to Capital Gains Tax

Starting back in 2006, capital gains tax law had a sunset provision, and unless approved by congress, was scheduled to revert back to the previous rates of around 20% in effect prior to 2003.  The American Taxpayer Relief Act of 2012 made several important changes to the treatment of capital gains, and eliminated the sunset provision, adding stability and permanence to these rules:

  • Income Thresholds:  individuals in the 10% and 15% tax brackets will pay 0% on gains from eligible dividends and most capital gains.
  • Qualified Dividends:  income received will be taxed at the same rate as long-term capital gains.
  • Tax Rate:  individuals in the 25%, 33% and 35% federal income tax brackets will pay 15% on capital gains, while taxpayers in the 39.6% bracket will pay 20%.

Essentially, there are now three tax rates that apply to long-term capital gains.  Individuals in the 10% and 15% federal income tax brackets pay 0%, while those in the 39.6% bracket pay 20%; all other taxpayers owe 15%.  Short-term capital gains are taxed at an individual's "normal" incremental tax rate.

Starting in 2013, taxpayers above certain income thresholds will also pay a 3.8% Medicare tax on investment income, thereby increasing the effective rate on capital gains to 23.8% (20% + 3.8%) for some taxpayers.

Important Exclusions from Capital Gains Tax

There are several very important exclusions from capital gains that are worth mentioning.  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, the loss can be used to offset a gain.  This is one of the reasons many taxpayers sell investments that have lost value at year's end.  The capital loss will help to offset capital gains 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 they're 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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