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Certain things happen with age that we don’t even realize. Our hormones change, our brains get smaller and St. Patty’s day celebrations start to wane. We also begin to accumulate capital assets as we become more financially “mature.” Capital assets include items such as real estate, cars, stocks, bonds and other investment types such as mutual funds and ETFs. Apart from certain personal use items like cars or boats, the goal for most capital assets is that their value will increase over time. Since this is tax season, you might get where we’re going here; just like with income, when you make money on a capital asset, the IRS wants its cut.
Note: Capital gain tax does not apply to capital assets held inside IRAs or other retirement plans, which are sheltered from the taxation described below.
If you sell an asset for more than you paid for it, you will realize a capital gain. If you sell it for less than what you paid, you will realize a capital loss. The operative word here is sell. There will be no tax on your assets appreciating in value, until you sell them (also known as “realizing” a gain).
Capital gains and losses are classified as long-term or short-term. If you hold an asset for more than one year before selling it, the capital gain or loss is long-term. If your holding period is one year or less, the gain or loss will be considered short-term. This categorization matters for tax purposes. Gains realized on assets held for more than a year are taxed at lower rates than short-term assets. For most tax payers, the federal tax rate applied to long-term gains will be between 0%-15%. In 2017, the maximum long-term capital gain tax rate is 23.8%. Compared to the maximum income tax rate of 39.6%, you can see the preferential tax treatment given to long-term investments (both rates were the same in 2016). Short-term capital gains, on the other hand, are considered ordinary income for tax purposes, and are taxed as such. With the exception of a handful of states, state tax will also apply to realized gains, the amount and treatment of which varies by state.
Once a gain is realized and the appropriate amount of tax is paid, you can pretty much consider it a wrap. Losses, however, linger for tax purposes, which is a good thing. Capital losses that exceed gains in a given year can be used to offset income and future gains. Let’s say, for example, that, in year one, you sell a bad real estate investment for a $75,000 loss and gains on other assets for the year total $10,000. Your net position is a $65,000 loss. The IRS allows you to use $3,000 of this loss to reduce ordinary income for the year and any remaining losses can be used to offset future gains. Let’s assume that in year two, you have net gains of $25,000. You may use your remaining loss carry forward of $62,000 ($65,000 - $3,000) to fully offset this gain, plus another $3,000 to offset ordinary income. Headed into year three, you still have $34,000 in losses to be applied toward future years ($62,000-$25,000-$3,000).
Note: Losses from the sale of certain personal-use property, such as your home or car, cannot be used to offset gains or reduce income.