It’s everyone’s favorite time of year: tax time! As you’re filing your taxes this year, you will undoubtedly be faced with a lot of tax lingo. It can be overwhelming if you are not familiar with the terminology. A common tax question is “did you buy or sell any assets this year?”. This question is really getting at the treatment of a capital gain or capital loss. Now, you may prefer to turn over the documents showing this information to your tax software or CPA, but understanding how a capital asset is taxed can help you make smart decisions during the tax year.
First off, capital gains or losses apply to capital assets. So, what is a capital asset? Essentially a capital asset is everything from the home you live in, to the basketball shoes you sold, to your stocks and bonds. Capital assets are viewed differently and follow a different set of rules than, say, income from your job. Income from your job is typically subject to marginal income tax rates, while proceeds from the sale of a capital asset follow a different schedule.
To start, when you purchase a home or a stock, you pay a price. The price you pay for an asset, generally, is what the tax code calls your cost basis. Next, the fair market value of that investment will fluctuate over time. At some point, the value of the asset may be below its cost basis (a loss) and, at other points, the value of the investment may be above what you paid for it (a gain). Now when you want to sell this asset, how do you know what the tax implications will be? You need to look at the current price minus the cost basis. This number is known as your capital gain, if it’s positive, or your capital loss, if it’s negative. Once you know what your capital gain or loss is, you will need to add in one more variable: time.
When determining the tax cost or benefit of selling a capital asset, time is a big factor. The amount of time you have held the asset is referred to as your “holding period”. If your holding period for the asset is 1 year or less, your capital gain/loss will be treated as a short-term capital gain/loss. If your holding period for the asset is 1 year and 1 day (yes, this is important), your capital gain/loss will be treated as a long-term capital gain/loss. This distinction is vital to understand to appreciate the benefits that can come with capital assets.
Now that we have identified what category the capital gain/loss falls under, we can start teasing out the implications. A short-term capital gain is taxed at your marginal income tax rate, just like income from your job. A short-term capital loss can offset a capital gain and subsequently offset up to $3,000 of ordinary income (if the loss is greater than the gain). On the other hand, a long-term capital gain receives preferential tax treatment at the Federal level. For example, the married couple that makes between $115,000 – $575,000 pays 15% on any long-term capital gains, compared to between 22% – 35% for short-term capital gains. That’s a huge tax savings for being savvy about your timing!
There are situations where you may have a mix of different capital gains and losses. To determine the implications, you will first need to add up all your short-term capital gains/losses and your long-term capital gains/losses to determine a total short-term capital gain and a total long-term capital gain. If both are positive, each capital gain is taxed in accordance with its short- or long-term status.
But what if one is negative and the other is positive? you will need to determine a “net capital gain”. For example, a $10,000 long term capital gain and a $3,000 short-term capital loss results in a $7,000 net long-term capital gain. A $3,000 long-term capital gain and a $10,000 short-term capital loss results in $7,000 short-term capital loss. If you have a net capital loss in any given year, up to $3,000 can be used to reduce ordinary income. Any amount above that $3,000 is then carried forward to future years in accordance with its tax status.
Taxes are a large part of any long-term financial plan. An advisor at Griffin Black can help you understand the tax implications of the sale of any capital assets and help formulate a long-term tax strategy that takes advantage of these tax rules to keep more money in your pocket and help you to live the life you want.
