Capital Gains Overview and Some Definitions
Sell stuff for more than it cost you? Capital gains. As you can imagine this is an incredibly broad topic that will impact everyone eventually, whether you sell a house, a beanie baby, or that pokemon card you’ve been holding onto since your childhood
Line 7 of the 1040 is for the disclosure of capital gains and losses. What is a capital gain? Well, a capital gain is the sale of a capital asset. A capital asset is… nearly everything that you own. It’s easier to define what isn’t a capital asset and then assume that everything else is a capital asset.
Things that are NOT capital assets(this list is not exhaustive but it does include everything that could be relevant to 99% of people):
Inventory held for sale to customers through the ordinary course of your trade or business.
Accounts receivable (an account receivable is the amount owed to a business for services or goods that hasn’t yet been paid).
Depreciable property (depreciable property is property used in your business that you are required to depreciate by claiming business expenses for your possession/use of the property. I.e. if you own a pizza restaurant and you buy an expensive brick oven to make your pizza, you will depreciate that oven by claiming an expense based on the cost of the oven).
Real estate used in your trade or business.
Most intellectual property (inventions, designs, books, music, etc) created by or for you.
Supplies regularly used in your trade or business.
Pretty much everything else is a capital asset. Examples of things that are capital assets: any stock that you own, your house, your dining room table, your dog, your childhood Barbies/Ninja Turtles, your shoes, the tree in your front yard, and the list of examples could go on indefinitely.
If you sell a capital asset for more than you paid for it, you have a capital gain. Now, it’s not always this clean cut // straightforward. There are some costs that can increase ‘the amount you paid for it’ for tax purposes. For example, you buy a piece of land, we’ll call it Property 1, for $100,000 and you proceed to build a house on it for another $100,000. If you later sell Property 1 for $300,000, your capital gain will only be $100,000 because the house you built on the land was a ‘capital improvement’ and is included when determining your capital gain.
The technical tax term for the amount you use as your investment in a particular capital asset to determine your capital gain when you sell it, is ‘basis’. Using the above example, your basis in the property includes the amount you paid for the land and the amount you spent in building the house on that land.
The two most common reasons that your basis is adjusted are capital improvements (as discussed above in the context of the house) and depreciation.
Depreciation is another technical tax term that refers to the amount of the value of a capital asset that you have been able to use as an expense to reduce/offset income. Not every capital asset is depreciable. Continuing with the above example, if you decide to rent Property 1 you can depreciate the value of the structure (the $100,000 house) yearly to reduce your rental income. (there will be a future article that more thoroughly explains depreciation). With a residential rental property you will depreciate 3.636% of the property each year, in this case $3,636. This means that after renting the property for five years and reducing your basis in the house by $3,636 each year, your basis in the property (including the land and the house) would be $181,820($200,000 - 5*($3,636)).
The technical tax term for the amount you receive when you sell a capital asset is ‘proceeds’. Your proceeds will include any cash you receive as well as the cash value for any non-cash items that you receive. Does this mean a trade is a sale? Yes, it does, a trade is a sale.
If you take Property 1 and trade it for a 1999 Lamborghini Diablo that is valued at $269,898, you will have to recognize capital gains of $69,898, which represents the difference between the proceeds (value of the Lamborghini) and your basis (the $100,000 you paid for the land plus the $100,000 you paid to build the house).
Taxing Capital Gains
Capital gains are also taxed a bit differently than other types of income. We divide capital gains into two primary categories, long term capital gains and short term capital gains. If you’ve owned something for one year or less, when you sell it, it will be classified as short term capital gains. If you hold it for longer than one year, it will be long term capital gains. This is a very important distinction as the tax rate applied to long term capital gains is normally significantly lower than the tax rate applied to short term capital gains. Short term capital gains are taxed at your marginal rate and long term capital gains are taxed at the applicable long term capital gains rate.
Your marginal rate (as explained here) is applied to your short term capital gains to determine the tax. There are only three different brackets for long term capital gains, they can be taxed at 0%, 15%, or 20%. As is the case with all tax brackets, your filing status impacts the tax brackets.
If you file single for 2020: if your income is $40,000 or under, your capital gains will be taxed at 0%; if your income is between $40,001 and $441,450, your capital gains will be taxed at 15%, and if your income is over $441,450, your capital gains will be taxed at 20%.
If you file married filing jointly for 2020: if your income is $80,000 or under, your capital gains will be taxed at 0%; if your income is between $80,001 and $496,600, your capital gains will be taxed at 15%, and if your income is over $496,600, your capital gains will be taxed at 20%.
If you file married filing separately: if your income is $40,000 or under, your capital gains will be taxed at 0%; if your income is between $40,001 and $248,300, your capital gains will be taxed at 15%, and if your income is over $248,300, your capital gains will be taxed at 20%.
This can provide you with the ability to do a bit of tax planning if ever you find yourself in a situation wherein your income for a particular year is going to be low enough to allow you to generate some capital gains while staying in the 0% capital gains bracket.
To demonstrate the difference between items being taxed as long term capital gains compared to short term capital gains, let’s revisit the $300,000 sale of property 1 above. If your taxable income for 2020 was $100,000 on a married filing jointly return (not including the sale of Property 1) and your sale of Property 1 was classified as a short term capital gain, the additional amount of income tax you would owe on that $100,000 of capital gains from the sale is $22,579. If your sale of Property 1 was classified as a long term capital gain, the additional amount of tax you would owe on that $100,000 of capital gains from the sale is $15,000. As you can see, it will clearly be worthwhile to try to wait until you hold an asset for longer than one year if you expect there to be a significant amount of capital gains.
Exceptions and Limitations
Some specific types of assets require special treatment when they are sold. These assets include collectibles (including things like gold and silver), your home(principal residence), assets you inherited, depreciable business assets, and PFICs. We will eventually have separate articles on each of these items that you will be able to click through to find more details on how each of these are reported.
I do want to take a few minutes to separately discuss capital losses. It’s important to understand the limitations applicable to capital losses. The first limitation on capital losses is the limit on your ability to deduct them against other types of income. Capital losses can always be applied to reduce capital gains, but if the net value of all of your capital gains and capital losses is a loss, you will only be able to deduct $3,000 of this loss on your current year return, and the remainder will become a capital loss carryforward that you can apply to capital gains in future years.
The second limitation to capital losses is the limit on your ability to deduct any losses from the sale of personal property. This means if you sell anything that you bought for personal use for a loss, you will not be able to claim any of that loss. This limitation applies to everything from the sale of your home, to the sale of your car, to the sale of your furniture, etc.
Take Home Points
If you’ve sold something for more than you paid for it, you’re going to have to include those capital gains on your tax filings, whether you’ve sold it for cash or traded it for something. (if your proceeds exceeds your basis, you have capital gains).
Always try to hold any asset that has increased in value for over one year, so that you can receive long term capital gains treatment and limit the amount of tax that you’ll have to pay on that sale.
Pay attention to the marginal tax bracket that you will be in as you may have an opportunity to sell some assets and report the income at an even lower rate (potentially as low as 0%).
Reporting capital gains isn’t always straightforward and there are a number of exceptions and limitations. Don’t expect to receive any tax benefits for losses on the sale of personal property, even if that personal property is your home.
