Nobody ever accused the tax code of being simple, and the sections dealing with capital gains and losses are no exception. We thought a brief primer on what constitutes capital gains and losses and how they are taxed would be helpful.
The basic premise of capital gains tax was that rich people were making money through the appreciation of their investments but weren’t paying taxes on these “earnings” because the tax code didn’t consider them to be “regular income” in the same sense that a salary or earnings from a small business were. Capital gains weren’t being taxed, and that bothered Congress. To remedy the problem, the IRS proposed, and the Congress put into law, a capital gains tax to make sure that wealthy Americans paid their fair share while sipping martinis at lunch.
The problem with this whole approach was that average, everyday Americans started falling subject to the capital gains tax in addition to the regular income taxes they paid on their salaries, because more and more Americans were investing in the stock market and realizing gains themselves. Thus, our elected leaders began tinkering with the capital gains rates in order to bring about some type of perceived fairness whereby speculators who earned their gains quickly would pay higher rates than serious long-term investors who earned their gains slowly.
The amount of the capital gain or capital loss is simply the difference between what you sell an investment for and the total amount it cost you to purchase. The length of time between your purchase and your eventual sale is critical. It’s called the “holding period.”
If you sell an investment twelve months or less from the date you purchased it, your gain or loss on the sale will be considered a short-term gain or loss. Congratulations, by the way, you are a speculator and subject to the highest tax, so don’t do that again! If, on the other hand you sell that investment more than one year after the date you purchased it, you are a good guy (or gal) because you are a serious, long-term investor, and you get a more favorable rate.
As an aside, don’t confuse any of these definitions with the term “short-sale”. A short sale is a very specialized investment strategy. Any gain or loss from a short sale is always considered short-term regardless of how long you really owned the investment. Politicians love to do things like that to confuse us. Moving along, let’s look at how these capital gains and capital losses are taxed.
Any short-term gain is taxed as ordinary income. This is not good for you, since the regular income tax rates are demonstrably higher. You would think that any short-term loss would therefore be treated as a deduction against your ordinary income, but you’d be wrong. You get to deduct only $3,000 of your short-term loss against your ordinary income in any one year. If your short-term loss is greater than that, you can “carry-over” the extra amount and use $3,000 of it each year as a deduction until the entire short-term loss is used up.
Long-term capital gains and losses are treated in a somewhat more complicated fashion. The weirdest part of the treatment is the special treatment given to the long-term gain if it is generated by the sale of specific investments that Congress wanted to single out. We won’t delve into any of these now. Just know that the discussion below may be altered if your investment falls into one of these special categories. There aren’t a lot of them, but you should always check with your tax preparer.
Assuming that we’re dealing with a “regular” investment, long-term capital losses have to be used to offset long-term capital gains first, then they could be used to offset short-term gains. If you don’t have any gains to offset, you get to carry-over the long-term losses to a future year when you have gains to offset.
Again assuming that we’re dealing with a “regular” investment, long-term capital gains are taxed at one of three different rates, depending on your tax bracket for regular income. These are quickly summarized in the table below.
|Regular Income |
|Long-term Capital |
Gains Tax Rate
Remember, these apply to long-term gains only, but as you can see, there are some large differences among these rates. While you should never let the tax “tail” wag the prudent investing “dog,” the long-term short-term distinction should be considered if you are thinking about selling an investment at a gain and are getting close to the holding period boundaries, especially if you are close to qualifying for long-term treatment.
Long-term and Short-term Confusing
Now for some real fun. What happens if you have some combination of both short-term capital gains and losses, as well as long-term gains and losses? As cleanly as we can present them, here are the rules for computing your tax exposure when you have combinations of short and long term holding periods.
First, you combine your short-term losses and short-term gains to arrive at your net short-term gain or loss.
Second, you combine any long-term losses and long-term gains to arrive at your net long-term gain or loss.
Third, if you have a gain in one category and a loss in another category, and your overall total is a gain, then this overall gain will be put into the same time category as the time category that had the gain. In simple form, here’s what it looks like:
|Long-term Category||Short-term Category||Overall Gain/Loss||Tax Treatment|
|+$10,000||-$4,000||+$6,000||Long-term, taxed at maximum of 15%|
|-$4,000||+$10,000||+$6,000||Short-term, taxed at regular income tax rate|
The same applies to losses:
|Long-term Category||Short-term Category||Overall Gain/Loss||Tax Treatment|
|-$10,000||+$4,000||-$6,000||Long-term loss; use $3,000 carryover remainder|
|+$4,000||-$10,000||-$6,000||Short-term loss; use $3,000 carryover remainder|
As noted directly above, you can deduct $3,000 of your overall net loss against your regular income. The remainder can be carried over into future years and used to offset gains in those years. If you do not have gains in future years, you can continue to deduct $3,000 of the carryover amount each year until it is consumed.
So there you have it – a relatively thorough, yet simple, explanation of capital gains and losses as Congress intended them to be. Allow us now to throw in a monkey-wrench. Actually, since we don’t want to get blamed for this one, we should point out that Congress created this monkey- wrench; we’re only reporting it, so please don’t shoot the messenger.
Since your overall net capital gains and losses are fully part of adjusted gross income (AGI), you might see the benefits of the long-term capital gains tax rates disappear if you make too much money. There are phase-outs and restrictions which primarily flow out of the alternative minimum tax (AMT). Unfortunately, this piece of legislation is so complicated, it would be almost impossible to summarize in a brief article. The only general guideline we can offer is to say that if you think you make a lot of money, and if you have a really large mortgage, and/or if you live in a high cost-of-living/high tax state (like NY or CA), you probably will flirt with the AMT. Check with your tax preparer to determine if these rules apply to your situation.
Thanks for reading along on this journey through the forest of confusion that has become our tax code. Despite protestations of “tax simplification” by your congressional representatives, the code was never meant to be simple. If you’re still a bit confused at this point, don’t worry, you’re normal. Hopefully, this brief review has given you a working acquaintance of the issues at play as you consider when to sell your investments. Ultimately, though, you need solid advice from a tax professional.