Several key rules and processes impact how taxpayers
are taxed on capital gains and losses.
First, long-term gains and losses must be
separated from short-term gains and losses. Long-term, for these
purposes, means gains or losses from investments which you held for more
than a year. Gains and losses from investments held for one year or
less are short-term. In addition, long-term gains and losses must be
separated into three rate groups:
(1) the
28% group, consisting of:
-
Capital gains and losses from
collectibles (including works of art, rugs, antiques, metals, gems,
stamps, coins, and alcoholic beverages) held for more than one year;
-
Long-term capital loss
carryovers; and
-
Section
1202 gain (gain from the sale of certain small business stock held for
more than five years that's eligible for a 50% exclusion from gross
income).
(2) the
25% group, consisting of “unrecaptured section 1250 gain”—that is, gain on
the sale of depreciable real property that's attributable to the
depreciation of that property (there are no losses in this group); and
(3) the
15% or 5% group, consisting of long-term capital gains and losses that are
not in the 28% or 25% group. This includes most gains and losses from
assets held for more than one year.
Within each of the three groups listed above, gains
and losses are netted to arrive at a net gain or loss.
The following additional netting and ordering rules
apply:
(1)
Short-term capital losses (including short-term capital loss carryovers) are
applied first to reduce short-term capital gains, if any, otherwise taxable
at ordinary rates. If you have a net short-term capital loss, it
reduces any net long-term gain from the 28% group, then gain from the 25%
group, and finally reduces net gain from the 15%/5% group.
(2)
Long-term capital gains and losses are handled as follows. A net loss
from the 28% group (including long-term capital loss carryovers) is used
first to reduce gain from the 25% group, then to reduce net gain from the
15%/5% group. A net loss from the 15%/5% group is used first to reduce
gain from the 28% group, then to reduce gain from the 25% group.
If, after the above netting, you have any long-term
capital gain, the gain that's attributable to a particular rate group is
taxed at that group's marginal tax rate—28% for the 28% group, 25% for the
25% group, and the following rates for the 15% or 5% group:
5% in the
case of gain that would otherwise be taxed at a regular tax rate below 25%,
i.e., at 10% or 15%;
15% in the
case of gain not subject to the 5% rate described above.
If, after the above netting, you're left with
short-term losses or long-term losses (or both), you can use the losses to
offset ordinary income, subject to a limit. The maximum annual
deduction against ordinary income for the year is $3,000 ($1,500 for married
taxpayers filing separately). Any loss not absorbed by the deduction
in the current year is carried forward to later years, until all of it is
either offset against capital gains or deducted against ordinary income in
those years, subject to the $3,000 limit. If you have both net
short-term losses and net long-term losses, the net short-term losses are
used to offset ordinary income before the net long-term losses are used.
Dividends taxed at long-term capital gains
rates. Dividends that you receive from domestic corporations and
“qualified foreign corporations” are taxed at the same rates that apply to
the 15%/5% group mentioned above. However, these dividends aren't
actually part of that group, and aren't subject to the grouping and netting
rules discussed above.
Some planning suggestions.
Since losses can only be used against gains (or up to $3,000 additionally),
in many cases, matching up gains and losses can save you taxes. For
example, suppose you have already realized $20,000 in capital gains in Year
1 and are holding investments on which you have lost $20,000. If you
sell the loss items before the end of the year, they will “absorb” the gains
completely. Alternatively, if you wait to sell the loss items in Year
2, you will be fully taxed on Year 1 gains and will only be able to deduct
$3,000 of your losses (if you have no other gains in Year 2 against which to
net the losses).
Another technique is to seek to “isolate” short-term
gains against long-term losses. For example, say you have $10,000 in
short-term gains in Year 1 and $10,000 in long-term losses as well.
You're in the highest tax bracket in all relevant years (assume that's a 35%
bracket for Year 1). Your other investments have been held more than
one year and have gone up $10,000 in value, but you haven't sold them.
If you sell them in Year 1, they will be netted against the long-term losses
and leave you short- term gains to be taxed at 35%. Alternatively, if
you can hold off and sell them in Year 2 (assuming no other Year 2
transactions), the losses will “absorb” the short-term gains in Year 1.
In Year 2, the long-term gains will then be taxed at only 15% (unless the
gains belong in the 25% or 28% group).
Family tax planning opportunity.
Given the 5% capital gains rate for low bracket taxpayers, if you have
appreciated stock or other capital assets that you are thinking of selling,
you may wish to consider transferring the asset to children over 13.
To the extent their other taxable income would be taxed at a regular tax
rate of less than 25% (i.e., for 2004, taxable income of less than $29,050
for single returns; for 2005, taxable income of less than $29,700 for single
returns), they can take advantage of the 5% rate for net capital gains.
(For children under 14 the “kiddie tax” rules can cause the child's income
to be taxed at the parent's higher tax rates.)
Alternative minimum
tax.
The favorable rates that apply to long-term capital gain (and qualified
dividend income) for regular tax purposes also apply for alternative minimum
tax (AMT) purposes. In spite of this, any long-term capital gains you
recognize in a year might trigger an AMT liability. This can happen if
the capital gains increase your total income enough so that your AMT
exemption phases out. The extra income from capital gains may also
affect your entitlement to various exemptions, deductions and credits, and
the amounts of those AMT preferences and adjustments, that depend on the
amount of your income.
