The Mystery of Capital Gains Tax
As a seller of a capital asset, you need to know that capital gains tax may apply. And the Internal Revenue Service says nearly everything you own is counted as a capital asset, whether you purchased it for personal consumption (for example, your car or your flat screen TV) or as an investment (for example, stocks or real estate).
Selling something for an amount that exceeds your “basis” for that item, that excess serves as your capital gain, and you need to report it on your taxes as such. Your basis is what you spent to get the item, including sales, excise and other taxes and fees, as well as charges for shipping and handling fees, and installation and setup. Furthermore, any improvement expenses that raise an asset’s value (for example, remodeling your rental condo’s bathroom) may be added to your basis. In the same manner, your basis will decrease as an asset depreciates.
Usually, your home will be exempt from capital gains tax. The biggest asset people usually have is their home, and depending on market conditions, they can make a huge capital gain when they sell it. The good news is it’s possible to exclude some of that gain or even all of it from the capital gains tax, as long as the following conditions are satisfied:
> You owned the property and used it as your primary residence for at least two years within the five-year period prior to the sale; and
> You haven’t excluded the gain from an earlier home sale that you made within a two-year period preceding the latest sale.
If the above conditions are met, you can exclude a maximum of $500,000 from your gain if you’re married and file jointly with your spouse, or $250,000 if you’re single.
The Effects of Length of Ownership
If the asset you’re selling has been your property for more than a year, the gain you make will be counted as a “long-term” capital gain. If the asset has only been your property for less than a year, it is called a “short-term” capital gain. And short-term gain taxes are dramatically higher compared to long-term gain taxes. If you’ve held an investment for barely a year, the capital gains tax rate is often higher – probably between 10% and 20% or even more.
This difference in tax treatment is one of the advantages a “buy-and-hold” investment technique has over investment strategies that call for constant buying and selling (for example, day trading). Also, bottom-bracket taxpayers are usually not taxed for long-term capital gains. In other words, between short-term and long-term capital gains, the difference could actually mean that a person will pay taxes or will not pay any taxes at all.
Capital Losses Offsetting Capital Gains
Selling an asset for lower than its basis produces capital loss. However, only capital losses from an investment – not from the sale of a personal property – can be used to offset capital gains.