When a capital asset (see definition below, 26 USC § 1221) is sold, the difference between the amount it is sold for and the book value (or basis – usually what you paid for it) is either a capital gain or a capital loss.
While capital losses may be deducted only on investment property, and not on property held for personal use, all capital gains must be reported.
Capital gains and losses are either long-term or short-term. The determining factor is how long the property was held before being sold. If it is held for more than one year, the capital gain or loss is long-term. If it is held for one year or less, the capital gain or loss is short-term.
If you have long-term gains in excess of your long-term losses, you have a net capital gain to the extent your net long-term capital gain is more than your net short-term capital loss, if any. The tax rates that apply to net capital gain are generally lower than the tax rates that apply to other income.
If your capital losses exceed your capital gains, the excess can be deducted on your tax return and used to reduce other income, such as wages. Keep in mind, however, that there is an annual limit and you should speak with a certified public accountant for information. Furthermore, if your total net capital loss is more than the yearly limit on capital loss deductions, you may carry over the unused part to the next year and treat it as if you incurred it in that next year.
Some important exclusions from capital gains tax that one should consider:
An individual may exclude up to $250,000, and married couples filing jointly $500,000, of any capital gains realized on the sale of real property. This exclusion applies if the property is used as the primary residence for at least two out of the prior five years.
In addition, if an individual realizes both a capital gain and a capital loss in the same tax year, then the loss can be used to cancel out a gain.
The following is a formula for calculating taxes due on a sale:
Net sale proceeds
- Adjusted basis
= Taxable gain on sale
x CGT rate
____________________
= Taxes due on sale
where the adjusted basis or net book value is calculated as
Original basis (total initial cost)
+ Capital improvement expenditures
- Accumulated depreciation
____________________
= Adjusted basis
26 USC § 1221
Capital Asset defined
For purposes of this subtitle, the term “capital asset” means property held by the taxpayer (whether or not connected with his trade or business), but does not include—
(1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;
(2) property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business;
(3) a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by—
(B) in the case of a letter, memorandum, or similar property, a taxpayer for whom such property was prepared or produced, or
(C) a taxpayer in whose hands the basis of such property is determined (other than by reason of section 1022), for purposes of determining gain from a sale or exchange, in whole or part by reference to the basis of such property in the hands of a taxpayer described in subparagraph (A) or (B);
(4) accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in paragraph (1);
(5) a publication of the United States Government (including the Congressional Record) which is received from the United States Government or any agency thereof, other than by purchase at the price at which it is offered for sale to the public, and which is held by—
(B) a taxpayer in whose hands the basis of such publication is determined, for purposes of determining gain from a sale or exchange, in whole or in part by reference to the basis of such publication in the hands of a taxpayer described in subparagraph (A);
(6) any commodities derivative financial instrument held by a commodities derivatives dealer, unless—
(A) it is established to the satisfaction of the Secretary that such instrument has no connection to the activities of such dealer as a dealer, and
(B) such instrument is clearly identified in such dealer’s records as being described in subparagraph (A) before the close of the day on which it was acquired, originated, or entered into (or such other time as the Secretary may by regulations prescribe);
(7) any hedging transaction which is clearly identified as such before the close of the day on which it was acquired, originated, or entered into (or such other time as the Secretary may by regulations prescribe); or
(8) supplies of a type regularly used or consumed by the taxpayer in the ordinary course of a trade or business of the taxpayer.
For purposes of subsection (a)(6)—
The term “commodities derivatives dealer” means a person which regularly offers to enter into, assume, offset, assign, or terminate positions in commodities derivative financial instruments with customers in the ordinary course of a trade or business.
(i) In general The term “commodities derivative financial instrument” means any contract or financial instrument with respect to commodities (other than a share of stock in a corporation, a beneficial interest in a partnership or trust, a note, bond, debenture, or other evidence of indebtedness, or a section 1256 contract (as defined in section 1256 (b))), the value or settlement price of which is calculated by or determined by reference to a specified index.
which is based on any current, objectively determinable financial or economic information with respect to commodities which is not within the control of any of the parties to the contract or instrument and is not unique to any of the parties’ circumstances.
For purposes of this section, the term “hedging transaction” means any transaction entered into by the taxpayer in the normal course of the taxpayer’s trade or business primarily—
(i) to manage risk of price changes or currency fluctuations with respect to ordinary property which is held or to be held by the taxpayer,
(ii) to manage risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer, or
Notwithstanding subsection (a)(7), the Secretary shall prescribe regulations to properly characterize any income, gain, expense, or loss arising from a transaction—
(i) which is a hedging transaction but which was not identified as such in accordance with subsection (a)(7), or
At the election of the taxpayer, paragraphs (1) and (3) of subsection (a) shall not apply to musical compositions or copyrights in musical works sold or exchanged by a taxpayer described in subsection (a)(3).
The Secretary shall prescribe such regulations as are appropriate to carry out the purposes of paragraph (6) and (7) of subsection (a) in the case of transactions involving related parties.
