Capital Gains Tax
With W-2�s already in the mail, and 2002 in the distant past, tax day will be sneaking upon us before we know it. For many, fears about proper reporting to the IRS brings utter chills. If you have sold or exchanged capital assets this past year, you will have to report your gains or losses. For those taking a stab at preparing their own returns, lets review some ABC�s of capital gains tax. Why is the subject so popular among fellow taxpayers? Gains on the sale of certain capital assets are taxed using a preferred rate. That alone is enough to charge debate around this controversial tax by all taxpayers.
There are three questions to consider when computing capital gains tax. First, whether you have sold a capital asset. Second, what is your cost basis, or the price you originally paid for that asset, and finally, what is your holding period. Capital gain is the difference between the sale price of a capital asset and its original cost basis. If you sell the asset for less than the original basis, you may have a capital loss that is tax deductible (more details about loss in, Taking a Loss).
Let�s determine what assets qualify for special tax privileges. Under the Internal Revenue Code, a capital asset is defined as almost everything you own and use for personal purposes or investments. Here are some examples: stocks and bonds, a home owned and occupied by you and your family, household furnishings, your car, jewelry, and collections such as stamps and coins. But, while seemingly all-inclusive, five types of property are specifically excluded under the Internal Revenue Code and are explained in IRS Publication 544, Sales and Other Disposition of Assets, under Chapter 2.
Next we need to figure the original cost basis of the asset. In general, it is the original price paid (minus any commissions or fees). Calculating the cost basis of stock or mutual funds can be tricky and requires good record keeping, especially if you have purchased shares at different times and prices. The IRS allows several methods to calculate cost basis when determining for shares of certain stocks and mutual funds.
A holding period is simply the amount of time you have owned an asset before disposing of it. Three holding periods are significant to capital gains tax. Assets held for one year or less are considered short-term and receive no preferred tax treatment. You�ll simply pay taxes on the gain at your �normal� tax rate. Those held for more than one year are considered long-term, and gain is taxed at a lower �capital gain tax rate�. Some capital assets held for more than five years are considered �super-long-term� and taxed at an even lower rate then long-term gain. This is known as Qualified 5-year Gain. However, there are some restrictions on receiving this preferential tax rate, depending on when assets were purchased, and according to tax bracket. A holding period�s start date depends on the kind of acquisition made. For purchases of stocks and bonds bought on a securities market, (may differ from U.S. Treasury notes and bonds purchased at auction) the holding period begins on the day after the trading date you purchased, and ends on the trading day you sell. With real property, the holding period generally begins the day after the date you receive title to the property.
Capital gains are reported to the Internal Revenue Service on Schedule D of Form 1040. Gains on assets held short-term are taxed at your ordinary income tax rate. Depending on tax bracket, this means either, 15% or anywhere from 28% to 39.6%. With a few exceptions, the highest tax rate on a net long-term capital gain is generally 20% (10%, if it would otherwise be taxed below 20%).
Capital gain is "stacked" on top of your other income, so it doesn�t push your earned income into a higher tax bracket. But, when computing your normal tax bracket for capital gains, take note that capital gain income is added to your earned income. Thus, the total amount, not just the portion related to earned income, will determine your tax bracket for capital gains. Using Schedule D you can compute the tax, using the preferred tax rate on your long-term capital gain.
Still preparing your own tax returns? Keep in mind that tax laws are in constant evolution. In 2001, the 10% capital gain rate was lowered to 8% for qualified 5-year gain. In 2006, the 20% capital gain rate will be lowered to 18% for qualified 5-year gain if the holding period for the property began after 2000. A taxpayer (other than a corporation) holding certain capital assets on January 1, 2001 can elect to treat the assets as sold and then reacquired on that date. The purpose of the election is to make any future gain on the property eligible for the 18% rate by giving the property a new holding period. However, any gain on the deemed sale must be recognized.
Further tax changes can always be anticipated. If you are still struggling, relief may be only a phone call or click away. The IRS offers ample resources including answers to numerous FAQ�s on its website, along with several free publications. It is recommended that you take the time to understand reporting requirements or seek professional help. No one wants the �tax man� knocking on his or her door.
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