What Is It?
If you sell or exchange a capital asset for more or less than your adjusted basis in the asset, the result is a capital gain or loss. It's important to understand both how and when capital gains and losses are generated, since capital gains and losses are afforded special tax treatment. The purpose of this discussion is to provide a general understanding of the concepts of capital gain and loss and an overview of how they are calculated.
Tip: Qualified dividends paid to individual shareholders from domestic corporations (and qualified foreign corporations) are taxed at long-term capital gains tax rates. However, dividends receiving capital gains tax treatment are not otherwise treated as capital gain income (i.e., they cannot be reduced by capital losses).
What Is a Capital Asset?
Capital assets consist of all assets and property other than the following:
- Depreciable business property
- Real property used in a trade or business
- Accounts or notes receivable
- Certain intellectual property in the hands of the creator (i.e., copyrights, musical or artistic compositions, letters or memoranda, or similar property)
- U.S. government publications
Tip: Investments and property held for personal use are usually considered capital assets.
Tip: An individual can elect to treat the sale or exchange of musical compositions or copyrights in musical works created by the individual's personal efforts as a sale or exchange of a capital asset.
What Is Your Basis In a Capital Asset?
In a very general sense, "basis" refers to your investment in an asset; that is, the portion that shouldn't be taxed when you sell the asset. The starting point in determining basis is always cost. Usually, the amount that you paid for an asset is your initial basis in the asset. That's not always the case, however; there are certain exceptions, as discussed in the following sections.
In addition, be aware that your "adjusted basis" in an asset is really the focus when determining capital gain or loss, not your initial basis. Certain items may increase or decrease your basis in a particular asset over time, resulting in your adjusted basis.
Increases to Basis
Many items can increase your basis. Regarding real property, for instance, you increase your basis in the property when you make capital improvements. Capital improvements include any improvement that has a useful life of more than one year.
Examples include putting an addition on your home or re-roofing your home. Assessments for local improvements (e.g., water connections, sidewalks) and certain legal fees (e.g., defending and perfecting title) can also increase your basis in real property.
For stocks and bonds, your basis is generally the purchase price plus any costs incurred in the purchase, such as commissions and recording or transfer fees.
Decreases to Basis
Basis can also be decreased. For example, the basis of business property may be reduced by Section 179 deductions or depreciation deductions, among other items.
Property Received As a Gift
To figure the basis of property that you receive as a gift, you need to know its adjusted basis to the donor just before it was given to you and the amount of any gift tax that was paid on it, if any. If the fair market value (FMV) was more than the donor's adjusted basis, your basis for figuring gain or loss is the same as the donor's adjusted basis at the time that you received the gift. This is known as a carryover basis. (However, you must increase your basis by the portion of the gift tax paid that resulted from the net increase in value of the gift.) If the FMV of the property at the time of the gift was less than the donor's adjusted basis, your basis for figuring gain is the donor's basis plus or minus any increases or decreases to basis (as discussed) while you held the property. Your basis for figuring loss is the FMV when you received the gift plus or minus adjustments to the basis while you held the property.
Caution: Special rules apply to gifts received before 1977.
Your basis in property that you inherit is usually its FMV at the date of the decedent's death. This is known as a step up (if the market value has increased) or step down (if the market value has decreased) in basis.
Example(s): Assume your grandfather bought a piece of property for $2,000. When he dies many years later, the property is worth $15,000. If you inherit the property, you'll take a stepped-up basis of $15,000.
If a federal estate tax return must be filed, your basis in the property can be its FMV at the alternate valuation date if the estate qualifies and elects to use the alternate valuation. For more information about the basis of inherited property, see IRS Publication 551.
A nontaxable exchange is an exchange in which you are not taxed on any gain and you cannot deduct any loss. If you receive property in a nontaxable exchange, its basis is usually the same as the basis of the property you exchanged.
A taxable exchange is an exchange in which the gain is taxable or the loss is deductible. If you receive property in exchange for other property in a taxable exchange, the basis of the property you receive is usually its FMV at the time of the exchange.
When Do You Realize Capital Gain or Loss?
You do not realize capital gain or loss unless there is a "realizing event." For most people, that means a sale, exchange, or other disposition of an asset.
Caution: Certain exchanges may be ignored for tax purposes. For example, a loss deduction may be disallowed if a sale or exchange involves related parties. Also, the IRS may scrutinize capital sales or exchanges to ensure that the transactions are "arm's length" ones, entered into in good faith.
How Do You Calculate The Amount of Your Capital Gain or Loss?
Your capital gain or loss equals the amount you realize on the sale or exchange of a capital asset minus your adjusted basis in the asset. Generally speaking, the amount that you realize in a sale or exchange is the amount of cash and/or the FMV of property that you receive (i.e., the sales price).
Example(s): Assume John had an adjusted basis of $50,000 in his house. Because he sold his house for $120,000, his capital gain for this transaction comes to $70,000 ($120,000 - $50,000).
Tax Consequences of Capital Gains and Losses
Capital gains and losses in a given year are netted in a prescribed manner to determine tax treatment. The taxation of capital transactions depends on a number of factors, including the type of asset, the length of time you held the asset before selling it (i.e., the holding period), and your marginal tax bracket.
Caution: A gain on the sale of property used for personal purposes is taxable as a capital gain. However, a loss on the sale of property used for personal purposes is not deductible as a capital loss. Deductible losses are limited to business losses, investment losses, and casualty and theft losses.
This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.
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