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Clearing the Air About Capital Gains and Losses
Unless you have an interest in accounting, the intricacies of the tax code with regard to capital gains and losses are most likely to bring on heavy eyelids if not outright dozing. That's at least in part due to the fact that there is no one-size-fits-all tax treatment of capital assets; instead, what you pay or deduct will depend on how you realized your gains and losses.
Let's see if we can clear the air a little bit by explaining what capital gains are and how the IRS goes about taxing them.
Capital Assets
All assets, in tax parlance, fall into one of two categories: capital and non-capital. Capital assets are those you hold for personal use or investment - your home, furnishings, automobiles, jewelry, coin and stamp collections and so forth. Non-capital assets are things such as sales to customers, accounts receivable, hedging transactions, business supplies and property used for business.
Come tax time, capital assets are subject to capital gains and loss rules. Sales of non-capital assets are taxed as ordinary income and thus are not included in this discussion.
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Capital Gain/Loss Sales
Just because an asset is considered capital doesn't mean you can deduct a loss if you sell it. In fact, losses on personal capital assets (your home, your car, etc.) cannot be deducted. Conversely, gains from the sale of personal capital assets may be taxable.
Once sold, a capital asset either makes money (gain) or loses it (loss). If you held the asset for a year or less, it is considered a short-term gain or loss; if you held it for longer, it is considered a long-term gain or loss. If the capital asset is personal property, the holding period begins the day you acquired it; if it's a security, it begins the day after you acquired it.
Capital Gain/Loss Scenarios
In addition to your straight trading gains, you face three possible gain/loss scenarios: short-term gains and losses; long-term gains and losses; and both short-and long-term gains and losses. Here's how you are taxed in each case:
- Short-Term Gains and Losses: Combine your short-term gains and losses to produce a net short-term total. If it's a gain, it is taxed as ordinary income. If it's a loss, you may deduct it up to $3,000 on your taxes. If your loss exceeds $3,000, you may carry it over to the following year where it remains a short-term loss.
- Long-Term Gains and Losses: Combine your long-term gains and losses to produce a net long-term total. If it's a gain, it is taxed at the maximum rate of 15%. If it's a loss, it is deductible up to the $3,000 cap and you may carry additional loss over to the following year where it remains a long-term loss.
- Short- and Long-Term Gains and Losses: If you have both short- and long-term gains and losses, first combine the short-term gains/losses to produce a net short-term total, then the long-term gains/losses to produce a net long-term total. Next, combine the two net totals. If that's a gain, each section is taxed at its applicable short-term or long-term rate. If it's a loss, it is deductible up to the $3,000 cap. If your loss exceeds the $3,000 cap, deduct your short-term loss first and carryover the long-term portion.
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Mixed Short- and Long-Term Gains and Losses
It is possible to end the year with a mix of short- and long-term gains and losses. Here's how to report the four possible scenarios:
- If your short-term gain exceeds your long-term loss: Take a short-term gain and treat it as ordinary income.
- If your short-term loss exceeds your long-term gain: Take a short-term loss to $3,000 and carry over the balance.
- If your long-term gain exceeds your short-term loss: Take a long-term loss to $3,000 and carry over the balance. The net gain will be taxed at long-term rates.
- If your long-term loss exceeds your short-term gain: Take a long-term loss to $3,000 and carry over the balance.
The Basics of Basis
Your gain or loss in a capital asset is determined by what is called your adjusted basis. Basis is the price you paid for the asset; adjusted basis is your basis plus additions such as selling expenses to transfer ownership or home improvements, minus deductions for depreciation or casualty loss.
What does this mean for securities trading? If you broker charges you to conduct trades, you may subtract his or her fees from your gain. But sure to read carefully the Form 1099 your receive from your broker at year's end. Some brokerage firms record gross gains and losses, meaning they haven't subtracted their expenses, while others record net gains and losses from which their fees have already been subtracted. Always use net gains and losses to calculate your taxes.
Confused about capital gains and losses? Contact a Traders Accounting tax professional today. Unlike most accounting firms, we know trading and the unique tax advantages that only apply to our industry. We can help you minimize your tax liability, simplify your bookkeeping and protect your trader tax status, now and into the future.
Jim Forrester, CPA is the Tax
Director of Traders Accounting, the nation's leading provider of tax
consulting, entity formation, tax preparation and 401(k) services to
the trading industry. Traders Accounting teaches traders how to
properly set-up their trading business and take advantage of all the
money-saving tax strategies available to home-based businesses.
Explore the website that Forbes has declared "Best of the Web" for
six straight years and find out exactly how to make your trading
into a 'business' and receive tax breaks and tax deductions worth up
to $25,000 each year. Visit www.tradersaccounting.com for more info.
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