Capitalizing Gains and Losses
The history of capital gains treatment stateside is interesting. As well, it is reflective of how the American tax authority periodically tampers with the tax law. From 1913 to 1921, capital gains were taxed at 7%. In 1921, a rate of 12.5% was applied to assets held for two years or more. From 1942, investors could exclude 50% of gains on assets held for at least six months. In 1978, the exclusion was increased to 60% against which 28% tax was applied. Three years later, this tax rate was lowered to 20%. The Tax Reform Act of 1986 repealed the capital gains exclusion and raised the maximum tax rate to 28%. In 2003 the rate was reduced to 15% for the higher tax brackets and 5% for the two lower ones (rates that apply to 2007 tax returns). In 2008, 2009 and 2010, the tax rate on long term capital gains has been lowered to 0% for anyone in the 10% and 15% income tax brackets. After 2010, this situation will change. A Single taxpayer whose taxable income is less than $32,550 will pay 5% on long term capital gains in 2007; 0% from 2008 - 2010. A married joint filer’s taxable income can be $65,100 for the 5% rate in 2007.
To take maximum advantage of capital gains tax rates, investors need to understand what happens when there is an interplay between short-term and long-term gains, the distinction being for assets held for more than one year before sold versus assets held for less than a year. Long term gains are taxed at the favorable capital gain tax rates. Short term gains are taxed at ordinary income tax rates.So a sale can be long term. Or it can be short term. When both sales occur in a tax year, four possible outcomes can occur:
- Long term gain with short term gain. The former is taxed at 5% or 15% depending on tax bracket. The latter is taxed with your other income up to 35%.
- Long term loss with short term gain. If the gain is bigger than the loss, you will be taxed up to 35%. If the loss is bigger, the resulting netlong term loss up to $3,000 for married joint filers can be taken to offset other income.
- Long term gain with short term loss. If the gain is bigger, you would have a net long term gain taxed at favorable capital gains tax rates. If the loss is larger, the resulting net short term loss up to $3,000 applies as in 2) above.
- Long term loss with short term loss. Long term losses offset long term gains while short term losses offset short term gains. But whenshort term losses exceed $3,000, you must use these up first to offset that ordinary income with the balance being carry-forwarded with the long term losses to a subsequent tax year(s).