Capital gains and losses are crucial in determining your tax liability on investments. This section breaks down how to calculate these figures, from establishing cost basis to recognizing gains or losses when you sell assets.

Understanding the tax rates for different types of capital gains is key to smart investing. We'll explore how holding periods affect your tax bill and dive into special situations that might impact your capital gains calculations.

Cost Basis of Capital Assets

Defining and Calculating Cost Basis

• Cost basis represents the original value of an asset for tax purposes
  • Usually equals the purchase price
  • Adjusted for certain factors
• Add purchase commissions and certain closing costs to the cost basis for real estate transactions
• Inherited assets typically use fair market value on date of decedent's death as cost basis
  • Alternate valuation date may be used in some cases
• Cost basis for gifted assets depends on fair market value at time of gift
  • Compare to donor's original basis to determine appropriate cost basis
• Employee stock options and dividend reinvestment plans have special rules for determining stock cost basis
• Real property improvements increase cost basis
  • Adding a room to a house (increases basis by cost of addition)
• Depreciation taken on property reduces cost basis
  • Rental property depreciated over 27.5 years lowers basis each year

Special Considerations for Cost Basis

• Accurate record-keeping crucial for all transactions affecting cost basis
  • Save receipts, statements, and documentation of improvements
• Stock splits and mergers may impact cost basis calculations
  • 2-for-1 stock split halves per-share basis but doubles number of shares
• Reinvested dividends increase cost basis of investments
  • $100 in reinvested dividends adds $100 to stock basis
• Wash sales can affect cost basis of replacement securities
  • Disallowed loss added to basis of new substantially identical securities
• Cost basis of property converted from personal to business use
  • Lower of adjusted basis or fair market value at time of conversion

Realized Gains and Losses

Calculating Realized Gain or Loss

• Realized gain/loss formula: Amount realized - Adjusted cost basis
• Amount realized includes:
  • Sale price of asset
  • Other consideration received (property, services)
  • Minus selling expenses (commissions, legal fees)
• Non-cash exchanges require determining fair market value of property/services received
• Special rules apply for personal residence sales
  • May exclude up to $250,000 gain ($500,000 for married couples) if eligibility requirements met
• Realized gain/loss may differ from recognized gain/loss
  • Tax-deferral provisions like like-kind exchanges can postpone gain recognition

Classifying and Reporting Gains and Losses

• Determine holding period to classify gain/loss as short-term or long-term
  • Short-term: Held 1 year or less
  • Long-term: Held more than 1 year
• Net gains and losses from multiple transactions during tax year
  • Short-term gains/losses netted separately from long-term
  • Then combine for overall capital gain/loss position
• Report capital gains and losses on Form 8949 and Schedule D
  • Provide details of each transaction
  • Calculate total net gain or loss

Capital Gains Tax Rates

Short-Term vs. Long-Term Capital Gains Rates

• Short-term capital gains taxed at ordinary income tax rates
  • Rates vary based on taxpayer's income bracket (10% to 37% for 2021)
• Long-term capital gains benefit from preferential tax rates
  • Generally lower than ordinary income tax rates
  • 0%, 15%, or 20% based on taxable income and filing status
• High-income taxpayers may owe additional 3.8% Net Investment Income Tax
  • Applies to investment income above certain thresholds ($200,000 for single, $250,000 for married filing jointly)

Special Capital Gains Situations

• Collectibles (art, antiques) taxed at maximum 28% rate for long-term gains
• Unrecaptured Section 1250 gains on depreciated real estate taxed at maximum 25% rate
• Qualified small business stock may be eligible for partial gain exclusion
  • Up to 100% exclusion if held for over 5 years and other criteria met
• Cryptocurrency transactions treated as property for tax purposes
  • Subject to capital gains rules when sold or exchanged

Tax Treatment of Capital Losses

Offsetting Gains and Income with Losses

• Capital losses fully offset capital gains regardless of short-term or long-term status
• Net capital losses can reduce ordinary income up to annual limit
  • $3,000 per year ($1,500 if married filing separately)
• Unused capital losses carry forward indefinitely to future tax years
  • Subject to same annual limitations
• Corporations have different capital loss rules
  • Cannot offset ordinary income
  • Limited carryback and carryforward periods

Restrictions and Special Rules for Capital Losses

• Wash sale rule disallows loss recognition if substantially identical securities repurchased
  • Within 30 days before or after the sale
  • Disallowed loss added to basis of new securities
• Personal-use property capital losses generally not deductible
  • Exceptions for certain casualty or theft situations
• Passive activity loss rules may limit deductibility of certain investment losses
• Tax benefit of capital losses potentially affected by Alternative Minimum Tax (AMT)
  • AMT calculations may reduce value of capital loss deductions