A capital gain or loss results from the sale, trade, or exchange of a capital asset. Simply stated, when the resulting transaction nets an amount lower than the original purchase value, or basis, of the capital asset, a capital loss occurs. When the resulting transaction nets an amount greater than the basis, a capital gain occurs. Capital gains and losses can either be short-term (when the transaction is completed within one year) or long-term (when the transaction is completed in more than one year). The period is determined from the day after acquisition of the asset to the day of its disposal. Capital gain/loss is a concept that affects small business owners in a number of ways—from the decisions they must make regarding their personal property and investments to the attractiveness of their businesses to outside investors. The factors relevant to capital gain/loss are the capital asset, the transactional event, and time.
The subject of capital gain/loss causes much debate in government and economic circles. The current philosophy centers on the benefits and efficiencies of capital accumulation and utilization. To encourage capital formation and investment, the federal tax codes tax capital gains at lower rates than ordinary income. In 1997, the maximum tax rate on a long-term capital gain was lowered from 28 percent to 20 percent (compared to maximum income tax rates of 31 percent, 36 percent, and 39.6 percent). A lower capital gains tax is supposed to encourage people to sell stock and other assets, which increases the government's tax revenues. In the past, it has also had a beneficial effect on investment in small businesses, as they tend to provide investors with income via an appreciation in stock price (which is taxed as a capital gain) rather than via dividends (which are taxed as ordinary income).
Everything one owns for personal use, pleasure, or investment is a capital asset. These include: securities, a residence, household furnishings, a personal car, coin and stamp collections, gems and jewelry, and precious metals. Since property held for personal use is considered a capital asset, the sale or exchange of that property at a price above the basis thus results in a capital gain, which is taxable. If one incurs a loss on that property from a sale or exchange, however, the loss cannot be deducted unless it resulted from a personal casualty loss, such as fire, flood, or hurricane. Other types of property and investments also have some irregularities in their treatment as capital gains or losses for tax purposes.
INVESTMENT PROPERTY, COLLECTIBLES, PRECIOUS METALS, AND GEMS All investment property is also considered a capital asset. Therefore, any gain or loss is generally a capital gain or loss, but only when it is realized—that is, upon completion of the sales transaction. For example, a person who owns stock in a growing technology company may see the price of that stock appreciate considerably over time. For a gain to be realized, however, the investor must actually sell shares at a market price higher than their original purchase price (or lower, in the case of a capital loss). Section 1244 of the federal revenue code treats losses on certain small business stocks differently. If a loss is realized, the investor can deduct the amount as an ordinary loss, while he or she must report any gain as a capital gain.
SALE OF A HOME The sale of a personal residence enjoys special tax treatment in order to minimize the impact of long-term inflation. For most people, a residence is the largest asset they own. While some appreciation is expected, residences are not primarily used as investment vehicles. Inflation may cause the value of a home to increase substantially while the constant-dollar value may increase very little. In addition, the growth in family size may encourage a family to step up to a larger home. To minimize the impact of inflation and to subsidize the purchase of new homes, the tax code does not require reporting a capital gain if the individual purchases a more expensive house within two years. In addition, individuals are entitled to exclude for tax purposes up to $250,000 and married couples up to $500,000 of capital gains from the sale of a home, provided they have lived in the home as a principal residence in two out of the previous five years. As of 2000, this exclusion was available to taxpayers every two years.
DETERMINING THE BASIS
Capital gain/loss is calculated on the cost basis, which is the amount of cash and debt obligation used to pay for a property, along with the fair market value of other property or services the purchaser provided in the transaction. The purchase price of a property may also include the following charges and fees, which are added to the basis to arrive at the adjusted basis:
1. Sales tax.
2. Freight charges.
3. Installment and testing fees.
4. Excise taxes.
5. Legal and accounting fees that are capitalized rather than expensed.
6. Revenue stamps.
7. Recording fees.
8. Real estate taxes where applicable.
9. Settlement fees in real estate transactions.
The basis may be increased by the value of capital improvements, assessments for site improvements (such as the public infrastructure), and the restoration of damaged property. A basis is reduced by transactional events that recoup part of the original purchase price through tax savings, tax credits, and other transactions. These include depreciation, nontaxable corporate distributions, various environmental and energy credits, reimbursed casualty or theft losses, and the sale of an easement. After adjusting the basis for these various factors, the individual subtracts the adjusted basis from the net proceeds of the sale to determine gain/loss.
NET GAIN OR LOSS
To calculate the net gain/loss, the individual first determines the long-term gain/loss and short-term gain/loss separately. The net short-term gain/loss is the difference between short-term gains and short-term losses. Likewise, this difference on a long-term basis is the net long-term gain/loss. If the individual's total capital gain is more than the total capital loss, the excess is taxable generally at the same rate as the ordinary income. However, the part of the capital gain which is the same amount as the net capital gain is taxed only at the capital gains tax rate, maximum 20 percent. If the individual's capital losses are more than the total capital gains, the excess is deductible up to $3,000 per year from ordinary income. The remaining loss is carried forward and deducted at a rate up to $3,000 until the entire capital loss is written off.