Tax Law can be a source of great amount of stress and frustration. The legal and financial issues surrounding tax law can be confusing and expensive. One of the most fundamental concepts of tax law surrounds capital gains and losses, the importance of which could make or break you financially.
Basic Tax Law Guidelines & Capital Gains & Losses Examples
The following are some basic guidelines and examples to help you understand what a capital asset is, and how a capital gain or loss could impact you. Overall, the general guideline is that most property you own is a capital asset.
Rule: When a capital asset is sold (such as real estate), the difference between what you sell it for and the “basis” (usually what you bought it for) is either a capital gain or capital loss.
- Example 1: Barry Buyer purchases raw land in 1980 for $100,000. In 2009 Barry sells it for $300,000. Barry needs to report a $200,000 tax gain.
Rule: You cannot deduct a loss on “personal use” property.
- Example 2: Barry sells his personal residence at a loss of $100,000 in 2011. Barry cannot deduct that loss.
- Example 3: Barry also has stock that he bought for $100,000 on 2/1/09 and later sold on 11/1/09 for $25,000. Barry can deduct the loss.
Rule: If a capital asset is held for more than one (1) year, then it is a long-term capital gain or loss on sale.
- Example 4: In example 1 above, Barry’s gain is a long-term capital gain because the asset (land) was held for over a year.
Rule: If a capital asset is held for less than one (1) year, then it is a short-term capital gain or loss on sale.
- Example 5: In example 3 above, Barry’s loss is a short-term loss because the asset (stock) was held for less than one (1) year.
What is the Procedure for Reporting a Capital Gain or Loss?
Now, that we addressed what capital assets are (almost everything you own) and have pointed out some of the main rules of thumb by example, it is important to spend some time on how you report a capital gain or loss once they are incurred. There are four steps to the procedure:
- Combine long-term gains or losses;
- Combine short-term gains or losses;
- Calculate the difference between (Step 1) and (Step 2)
- The Difference is what is reported on your Tax Return.
The IRS provides useful guidance on the implications of capital assets, as well as provides the required forms to report the same.
- Example 6: Let’s go back to Barry’s scenario in Example 1 & 3. Barry had a long-term capital gain of $200,000 in 2009 and a capital loss of $75,000 in the same year. Barry will report the difference ($200,000 – $75,000) = $125,000 Long Term Capital Gain.
Rule: If your capital losses exceeds capital gains, then you can apply a yearly limit of $3,000 (if married) to offset other income (wage income, for example). The unused portion can be carried over until the following year.
- Example 7: Let’s assume in Example 6 that there was no capital gain in 2009, so the only reportable transaction was a capital loss of $75,000. A married couple can deduct a maximum of $3,000 against other income. The remainder of $72,000 ($75,000 – $3,000) gets carried over to the following year.
How do you plan for Taxes on Capital Gains or Losses?
Planning for the tax consequences of a capital gain or loss on real property necessitates a full review of your overall financial position by qualified real estate attorney. If properly timed, an “underwater” property (one in which the fair market value of the property is less than the loan(s) amounts), can be used as a tax shelter of a capital gain on another asset.
- Example 8: Since the real estate slide of 2008-2011, you own an investment real property that has a potential capital loss of $150,000. Your primary residence that you’ve owned for many years has a reportable gain of $200,000. Selling both properties in the same year produces a capital gain of $50,000.