By JODI SUMMERS
If you are investing your money — in real estate, stock, rare coins or any sort of collectible that you buy as an investment — you should have a healthy understanding of how capital gains tax works. Those in the know say, “Mastery of this convoluted part of the tax code can both soften your losses and sweeten your gains.”
In many jurisdictions throughout the world, including the United States and the United Kingdom, a capital gains tax is charged on the profit realized on the sale of an asset that was previously purchased at a lower price. The most common capital gains are realized from the sale of stocks, bonds, precious metals and property.
We all have capital gains we can deduct from our income taxes. In any given year, only 7 percent of all taxpayers report capital gains. And, of those reporting, two-thirds of them make more than $100,000 a year.
In the United States, individuals and corporations pay income tax on the net total of all their capital gains, but the tax rate is lower for “long-term capital gains,” which are gains on assets that had been held for over one year before being sold.
Currently there are delicious incentives in place to motivate investment property owners to liquidate their real estate assets. For property sales transactions that conclude between May 6 and Dec. 31, 2013, the capital gains tax rate has been reduced from 20 percent to 15 percent. For those in the lower tax brackets, the tax is only 5 percent of the gain. In 2013, those reduced tax rates “sunset” and retreat back to pre- 2003 rates — around 20 percent. To get this complicated tax concept to work to your advantage, the first step is to understand how you are being taxed. A variety of variables come into play when you are calculating your tax rate: I Your income from other sources. I How long you have held the asset. Taxes on short-term gains — assets held for less than one year — are taxed as ordinary income, which can run as high as 35 percent. Taxes on long-term gains — assets held more than one year — can range from 5 percent to 28 percent.
I The type of asset. As government irony would have it, your trilobite collection would most likely be taxed at a higher rate than your mutual-fund shares.
Once you’ve got a grasp on the different rates, you can strategize and use your losses to offset your gains.
“Almost everything you own and use for personal purposes, pleasure or investment is a capital asset,” said Smartmoney.com’s Bill Bischoff. “The IRS says when you sell a capital asset, such as stocks, the difference between the amount you sell it for and your basis, which is usually what you paid for it, is a capital gain or a capital loss.”
Your cost basis is the difference between original purchase price. It’s adjusted for various things, including additional improvements or investments, taxes paid on dividends, certain fees, depreciation and the amount for which you sell the property.
Now for the exemptions: I One person can exclude up to $250,000 in capital gains on the sale of real estate if the owner used it as primary residence for two of the five years before the date of sale. This deduction jumps to $500,000 for a married couple filing jointly. For more information, check IRS Publication 523.
I In one of those funny government twists, you must report all capital gains, but you may deduct capital losses only on investment properties. If you or your business realize both capital gains and capital losses in the same year, the losses can be claimed as a tax deduction against ordinary income and taxable capital gains. For individuals, if losses exceed $3,000 in a year, any additional net capital loss can be “carried over” into the next year and again “netted out” against gains for that year. Corporations are permitted to “carry back” capital losses from prior years to offset capital gains, thus earning a kind of retroactive refund of capital gains taxes. See your accountant for details.
If you have taxable capital gains, you may be required to make estimated tax payments. See IRS publication 505, “Tax Withholding and Estimated Tax,” for more information.
Capital gains and losses are reported on Schedule D tax form, “Capital Gains and Losses,” and then transferred to line 13 of Form 1040. There is a worksheet in the 2005 Instructions to Schedule D to figure a capital loss carryover to 2006.
If you’re looking, you’ll notice that toward the end of each calendar year, there is a tendency for many investors to sell their investments that have lost value. Note the increased number of investment properties on the market come September.
I Individuals are able to defer capital gains taxes with tax planning strategies such as a charitable trust, installment sale, private annuity trust and a 1031 exchange.
The United States is unique in that its citizens are subject to U.S. tax on their worldwide income, no matter where in the world they reside. U.S. citizens, therefore, find it difficult to take advantage of personal tax havens.
Additional information on capital gains and losses is available in IRS publications 550, “Investment Income and Expenses,” and 17, “Your Federal Income Tax.” You may download the publications or order free copies by calling 1-800-TAX-FORM (1-800-829-3676).
For more information on capital gains, try www.smartmoney.com.
For making capital gains and other tax scenarios work for you, consult your accountant. (Jodi Summers is director of the investment division at Boardwalk Realty Santa Monica. Contact her at or call 310-309-4219. Visit her Web site at www.santamonica-landmarks.com.)
Originally published in the Santa Monica Daily Press print edition on February 22, 2006. Read the original PDF.