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Taxing Capital Gains and Losses

What Are They and How Are They Taxed?

You invest your money, you take the risk, and if it works out the taxman takes a piece of your gain.  Such is the way of things.  Gains come in kinds and if yours was a “capital” one then the tax bite may be smaller than if it were otherwise.  Losses come in kinds, too, but their tax treatment can be tricky, to say the least.

Your gain or loss is a capital one if the Internal Revenue Code (“IRC”) says the thing you sold was a capital asset.  Actually, the IRC says what isn’t a capital asset: inventory, depreciable property used in your trade or business, certain accounts receivable and copyrights, and a few other odds and ends (here’s a link to the full text, if you’re interested).  Note that this brief list of exclusions means just about anything a person might own and sell is a capital asset.

But capital gains and losses, too, come in types:  long-term and short-term.  Which you have depends whether you held the asset more than a year before selling it.  Selling a short-term capital asset will get you a bigger tax hit since the IRC likes to promote long-term investment.

As with most everything else in the tax code, figuring the tax on gains is relatively straightforward.  Losses, on the other hand, can muck up everything.

First, unless the capital asset was “held for investment” a loss on its sale isn’t deductible.  So if you sell that underwater home you’ve been sitting on, living in, raising your kids in, the amount you lose can’t be used to reduce your other income.[1]

Second, if you are an investor and during the year you had both winners and losers then things start to get complicated.  The general rule:  capital losses go against capital gains.  Short-term losses goes against short-term gains, long-term losses go against long-term gains.  After that, maybe, you can offset just a bit of your ordinary income.

It all depends on how the numbers work out.  Your net long-term results might be a gain (“NLTCG”) or a loss (“NLTCL”).  The same goes for your short-term results (“NSTCG” or “NSTCL”).

What happens when you try to combine the shorts and longs, to get to the bottom line gain or loss on the year?  It turns out there are exactly six possibilities:

  • NLTCG could be bigger than NSTCL
  • NSTCG could be bigger than NLTCL
  • You could have only net gains, both short-term and long-term
  • You could have only losses, both short-term and long-term
  • NLTCL could be larger than NSTCG
  • NSTCL could be larger than NLTCG

Each of these possible results has a different tax treatment and the applied tax rates can differ markedly, too.  Sometimes you can’t combine the net long and net short results together at all.  And even if you can you might (or might not) get the favorable capital gains tax rate.

Finally, if there are losses at the bottom line you don’t get to carry them all onto your form 1040 and offset other, ordinary income.  The maximum offset allowed is $3,000.  The rest you have to carry-forward to some future year (no limit) when hopefully you can use it to offset other capital gains.  This is tricky in its own right, though, since the carry-forward has to be characterized as either long-term or short-term and can only offset like-kind future gains.

No doubt this is all very confusing, in part because for the sake of brevity I’ve left out an awful lot of the details.  These rules are complex and sorting through them all can take awhile.

But complexity can be opportunity for the well-advised investor.  Knowing the rules allows you to play by the rules.  Planning ahead and filing correct returns can maximize your hard won gains and save you a world of hurt down the road.


 

[1] Gains on a personal residence, though, are mostly exempted from taxation.  More on that in another post.


This article is for informational purposes only and does not constitute legal advice.  You should consult a qualified attorney before taking any action.