For a couple of reasons I recently started reading up on capital gains taxes. I’m purchasing a condo in the next few weeks with the goal of selling it in a few years and realizing a capital gain. Also, I have a goal of earning a sufficiently high income to fully max out my retirement accounts and still have enough left over to invest in taxable accounts. Investing in taxable accounts requires a thorough knowledge of the effects of capital gains taxes in order to minimize taxes.
A capital asset is defined as everything you own and use for personal purposes, pleasure or investment. The following are examples of capital assets:
- stocks and bonds held in a personal account
- household possessions
- the real estate you live in
- your car for pleasure and commuting
- hobby collections
- gems and jewelry
- gold, silver and precious metals
Capital assets are subject to capital gains taxes when sold. For the most part all capital gains are subject to capital gains taxes, but not all capital losses are subject to deductions.
Capital Gain Versus Capital Loss
A capital gain is realized when a capital asset is sold at a price greater than the cost basis. The cost basis is most often, but not always, the original purchase price of the asset. A capital loss is realized when a capital asset is sold at a price less than the cost basis. Some capital assets can not be realized as capital losses for tax purposes, such as a car.
Long Term Versus Short Term Gains and Losses
Long term gains/losses are classified as held for more than a year. Short term gains/losses are classified as held for a year or less. The holding period for an investment is considered to begin on the day after the purchase and ends on the day of the sale. For example, if you purchase a stock on February 20, 2008 you will have to wait until February 21, 2009 to sell if you the gain to be considered long term. February 21, 2008 is considered the first day of the holding period and February 21, 2009 is one year later. It is important to understand the difference between a long term and short term capital gain as they are taxed at different rates.
Short Term Capital Gains Tax Rates
Short term capital gains are taxed at the ordinary income tax rates, which vary depending on income level and filing status. The figure below outlines the short term tax rates for 2008.
Long Term Capital Gains Tax Rates
Long term capital gains are taxed at varying levels according to the short term gains tax rate and the asset class. The figure below outlines the long term tax rates for 2008.
Primary residences have a special exclusion from capital gains taxes. Individuals can exclude up to $250,000 of capital gains on the sale of a primary residence. Married couples can exclude up to $500,000 of capital gains. The real estate must be used as the primary residence for two of the previous five years. The two years as primary residence don’t have to be sequential or the most recent two years. Unfortunately capital losses on the sale of a principal residence is not deductible.
Without getting too detailed (I will try to do so in a future post), capital losses may be used to offset capital gains, this practice is commonly referred to as tax loss harvesting. If capital losses exceed capital gains the capital loss may be taken as a deduction with a cap of $3,000. If there is an excess of capital losses by more than $3,000 the losses can be carried over to the next year. Certain capital assets can not be deducted or used to offset capital gains. Real estate and personal property, such as cars can not be realized as capital losses.
A thorough knowledge of capital gains and losses is crucial for investing outside of tax sheltered accounts. Done appropriately capital loss harvesting can have a huge impact on your overall investment return. Additionally, since I am purchasing my condo as an investment property and as my primary residence, I am hoping to take advantage of the exclusion from capital gains after I sell my condo for a huge increase (crossing my fingers). If you are looking for more information on utilizing capital gains/losses to your advantage consider signing up for automatic updates via e-mail or RSS as I will be blogging about tax loss harvesting and cost basis in the near future.