As most taxpayers already know, the sale of a capital asset potentially exposes the seller to a capital gains tax obligation. In order to avoid owing capital gains taxes, a basic understanding of capital assets and gains is in order.
What Is a Capital Asset?
Whether you realize it or not, you likely own capital assets. In fact, almost everyone owns some type of capital asset. According to the Internal Revenue Service, capital assets include almost everything you use for personal or investment purposes, including your home, your household furnishing, collectibles, and stocks and bonds held in a personal account.
What Triggers a Capital Gains Tax Obligation?
Typically, the goal of selling an asset is to make a profit as a result of the sale. When you sell a capital asset, the profit is referred to as capital gain. More specifically, capital gain refers to the difference between the basis of the asset and the ultimate sale price. Usually, the basis of an asset is the original purchase price; however, there are exceptions to this general rule. For example, if you purchased a home ten years ago for $100,000 and you sell it tomorrow for $150,000, then the capital gain on the sale is $50,000. The capital gain of $50,000 is then subject to capital gains tax unless it qualifies for an exemption or deferral.
Long-Term vs. Short-Term Capital Gains
Capital gains are divided into two categories – long-term and short-term capital gains. Long-term capital gains include gains realized on assets that were held for more than one year while short-term capital gains refer to the gain on assets held for less than one year. Long-term capital gains incur different tax obligations than short-term capital gains.
How Are Capital Gains Assessed?
Assessing the capital gains tax starts with determining your basis in the asset. You will then subtract your basis from the sale price to arrive at the realized gain upon which the tax is levied. Determining your basis in a capital asset is typically done in one of three ways:
- Purchased. If you purchased the asset outright then the price you paid for the asset is considered your basis.
- Inherited. If you inherit an asset then the basis is determined by the value of the asset on the date of death of the original owner.
- Gifted. If you received the asset as a gift, your basis is the amount that was originally paid for the asset unless the market value on the date of the gift was less than what was originally paid for the asset.
While these are the three most common methods of determining your basis, there are numerous exceptions to these general rules as well as adjustments to the calculations that may be required before you are ready to start figuring your capital gains tax obligation.
What Are the Current Capital Gains Tax Rates?
Because the IRS wants to encourage people to hold onto assets, gain realized on long-term assets are taxed at a lower tax rate than gain realized on short-term assets. Long-term gains are taxed at 0 to 23.8 percent rate dependent upon adjusted gross income except in the following circumstances:
- The taxable part of a gain from selling Section 1202 qualified small business stock is taxed at a maximum 28 percent rate.
- Net capital gains from selling collectibles (such as coins, precious metals or art) are taxed at a maximum 28 percent rate.
- The portion of any un-recaptured Section 1250 gain from selling Section 1250 real property is taxed at a maximum 25 percent rate.
Short-term capital gains, on the other hand, are taxed at your ordinary income tax rate. To learn about how to defer capital gains on property held in the productive use of a business or for investment, download “Ten Reasons Why a 1031 Exchange Makes Sense” by clicking on the button below.
