With all the recent market action I decided to contact Ryan Gibson, from Traders Accounting, Inc., to help explain a bit about how the IRS taxes capital gains. Ryan has always been my "go to" guy when it comes to explaining and UNDERSTANDING the world of accounting and taxes for trading. Please be sure and visit his site for more helpful information, Traders Accounting, Inc.
It’s a good thing China made its debut on the world stage by hosting the 2008 Summer Olympics and not, say, a spelling bee. After all, athletes speak a universal language: run faster, jump higher, throw farther or score more points than your opponents and you’ll bring home the gold, and possibly a Wheaties contract.
But try to order dinner in Beijing? Now that’s tricky. Centuries of cultural isolation have limited China’s exposure to the rest of the world until now, which is all part of the excitement of this year’s momentous Summer Games.
Tricky also might best describe how the IRS taxes capital gains. While it may not be as indecipherable as a Beijing Chinese menu, tax treatment of capital gains and losses are far from a one-size-fits-all proposition, but depends instead on how those capital gains or losses were realized.
Not-so-simple Capital Gains/Losses
First, a short primer on capital gains. For tax purposes, all assets fall into two categories: capital and non-capital. Generally speaking, capital assets are things we acquire for personal use or investment: our home, furnishings, vehicles and other valuables such as jewelry and collectables. By contrast, non-capital assets, as the term implies, tend to be impersonal: sales to customers, accounts receivable, business supplies, hedging transactions and property used for business.
The distinction becomes clear at tax time, when capital assets are subject to capital gains and loss rules. Sales of non-capital assets, however, are taxed as ordinary income, and so fall outside this discussion. A Traders Accounting professional can be invaluable in clarifying your capital gains position and minimizing your tax exposure.
When a capital asset is sold, it either makes money (gain) or loses it (loss), based on what is called adjusted basis. Basis is the price you paid for the asset. Adjusted basis is your basis plus such additions as selling expenses or home improvements, and minus deductions for such things as depreciation or casualty loss.
If you held the asset for a year or less, it is considered a short-term capital gain or loss; if you held it for longer, it is considered a long-term capital gain or loss.
Here’s where it gets trickier. Losses you incur on the sale of some capital assets, including personal items such as your home, furnishings and vehicles, cannot be deducted on your tax return. Similarly, gains from the sale of personal capital assets may be taxable.
Capital Gains Scenarios
Let’s look at three typical gain/loss scenarios to see how they would be taxed under the capital gains/loss rules:
1. Short-term gains and losses: In this situation, you would combine your short-term gains and losses to produce a net short-term total. A total gain is taxed as ordinary income, but a loss can be deducted up to $3,000 on your return. If your loss exceeds $3,000, it can be carried over to the following year as a short-term loss.
2. Long-term gains and losses: Combine long-term gains and losses to arrive at a net long-term total. A total gain is taxed at the 15% maximum capital gains rate. A long-term loss is deductible up to the $3,000 cap and can be carried over to the following year as a long-term loss.
3. Short- and long-term gains and losses: First, combine short-term gains and losses to produce a net short-term total. Next, combine long-term gains and losses to produce a net long-term total. Now combine the two net totals. If the result is a gain, each type of gain is taxed at its applicable rate (see above). If it’s a loss, it is deductible up to the $3,000 cap. If your loss exceeds $3,000, deduct your short-term loss first and carry over the long-term portion.
Mixed Doubles: Short- and Long-Term Gains/Losses
So what happens when you end the year with a mix of short- and long-term gains and losses? Here’s how the IRS taxes the four possible scenarios:
·Short-term gain exceeds long-term loss: The short-term gain is taxed as ordinary income.
·Short-term loss exceeds long-term gain: Deduct the short-term loss to the $3,000 cap and carry over the balance.
·Long-term gain exceeds short-term loss: Deduct the long-term loss to $3,000 and carry over the balance. The net gain is taxed at the long-term rate.
·Long-term loss exceeds short-term gain: Deduct the long-term loss to $3,000 and carry over the balance.
If your broker charges you to conduct trades, don’t forget to subtract his or her fees from your gain. And be sure to read carefully the Form 1099 you receive from your broker. Some brokers record gross gains and losses, meaning they haven’t subtracted their expenses, while others record net gains and losses, meaning they’ve already done the adjustment for you. Always use net gains and losses when preparing your tax return.
If you have any questions or need some advice please visit my site Traders Accounting, Inc.
Ryan Gibson, AZCLDP
Traders Accounting, Inc.