Capital gains are some of the most misunderstood things in taxes. To the average person, capital gain taxes are for rich people only. It conjures up images of “monopoly man” type characters with giant bags of money. Throwing their tsunami of cash in all directions. For others, capital gains are limited to stocks and maybe house sales. With that being said, what are capital gains anyways? And how do they affect your taxes on a yearly basis?
What is a Capital Asset?
In short, a capital gain (or loss), is the gain realized on a capital asset. This leads to the questions, “what is a capital asset?”. Well, a capital asset is defined in Topic 409 Capital Gains and Losses by the IRS as “Almost everything you own and use for personal, or investment purposes.”. This definition in my opinion is simple and thorough. Which for the Internal Revenue Service is incredibly rare. Some examples of capital assets are homes, personal use items, investment items like stocks, bonds, and even cryptocurrencies or currencies that are held as investments. The capital gain in this case is the gain on these assets/investments.
Short Vs. Long Term
Capital gains and losses are divided into two categories, short term, and long term. Short term capital gains are defined as gains on capital assets where the holding period is less than 12 months. Anything longer than 12 months is considered long term. The taxation for short term capital gains is the same as ordinary income. An example of ordinary income would be what you made from your job. However, the taxation for long term capital gains is very different. Long term capital gains are taxed at preferential rates. What does this mean? Well, it means that long term capital gains are taxed at lower rates than ordinary income would be. As of the 2021 tax season the maximum rate for most long-term capital gains is 20%.
Exceptions to Long Term Capital Gain Rates
However, there is a lot of talk about either raising the rates or potentially changing the rates to be tax the same as short term capital gains. Again, this would mean that long term capital gains could be taxed as ordinary income but obviously nothing is set in stone. Also, not to mention there are a couple of exceptions where the long-term capital gain, and these are:
- The taxable part of a gain from selling section 1202 qualified small business stock is taxed at a maximum 28% rate.
- Net capital gains from selling collectibles (examples are coins or art) are taxed at a maximum 28% rate.
- The portion of any unrecaptured section 1250 gain from selling section 1250 real property is taxed at a maximum 25% rate.
How To Report It on Your Taxes
Most capital gains and capital losses are reported on form 8949 “Sales and Other Dispositions of Capital Assets”. On this form you will calculate the proceeds (sale price), the basis (buy price), and make any adjustments, such as wash sales. After following the directions on the form, you will have a gain/loss total and this number will be reported on Schedule D which is conveniently called “Capital Gains and Losses”. The total capital gains and losses that are allowed will then be reported on Form 1040.
However, be aware about capital losses. As it currently stands if your capital losses exceed your capital gains your losses may be limited. The amount of the excess loss that you can claim to lower your income is the lesser of $3,000 ($1,500 if married filing separately) or your total net loss shown on line 16 of Schedule D, which will then be reported on your Form 1040. Also, another important exception to capital losses is that you cannot take losses on personal property, but you will have to report the gains on your Schedule D of Form 1040.
Conclusion
In summary capital gains are the gains that are realized on capital assets. Capital assets are roughly defined as anything that is owned personal or investments. Depending on the term of the investment the tax rates can different substantially. In addition, in some instances the rates can even vary among long term capital gains as well. These gains are reported on Form 8949 and Schedule D, before going on the 1040. However, everyone has a unique tax situation, and it is important to talk to a qualified CPA and/or a qualified tax professional.