Taxes on Capital Gains
When you sell a capital asset, you must calculate the difference between the sales price and your basis in the asset. If the sales price is more than your basis, you have a capital gain; if the sales price is less than your basis, you have a capital loss.
In most cases, your basis is the purchase price of an asset. However, some assets, like a home, may be improved over the years; improvements increase the basis. Let's say, for example, that you purchased your home in 1998 for $100,000. That's your basis. But if you built an addition onto the home that cost $25,000 in 2000, your basis in the home is now $125,000 (the purchase price of $100,000 + the addition cost of $25,000).With respect to stocks and bonds, your basis is the purchase price. Over time, the stock may split, spin off or have reinvested dividends. All these factors affect your basis, and it's important to keep track of them. Ideally, your investment adviser will keep this information organized for you.
Special rules apply for calculating basis for items that you inherit or receive as a gift. The rules for 2010 are particularly complicated since there is no federal estate tax: The basis of items received as an inheritance remains the same in the hands of the recipient. You might have heard this referred to as "carry-over" basis. This treatment is in contrast to years past when, if you inherited stocks or other appreciated assets, the cost basis would be "stepped up" to the fair market value as of the decedent's date of death. The advantage of stepped up basis is that it reduces or eliminates any capital gains taxes later when you sell the assets.
Without a stepped up basis, assets are subject to capital gains tax calculated on their "carry-over" basis when they are sold. There is some relief in 2010: Each estate is allowed to allocate $1.3 million of "stepped up" basis to certain assets (different rules apply for assets passing to a surviving spouse).
As a result of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, the federal estate tax returns in 2011 and with it, stepped up basis. The new law also offers estates of persons who died in 2010 the option of using the 2010 or 2011 rules. That means estates can elect a "no federal estate tax" scenario with carry-over basis or choose the federal estate tax exemption of $5 million with stepped up basis. Since this decision affects your capital gains tax and federal estate tax, it's a decision best made with the advice of your tax professional.
At federal income tax time, you'll report the sale of a capital asset on Schedule D of your federal form 1040. If you sell stocks and bonds, your broker or financial institution will report the sale proceeds on a form 1099-B; the IRS will also receive a copy of that form. You report the sales proceeds less the expenses of sale and your basis on Schedule D; the result is your capital gain. If you sell real property, the sales proceeds and the costs of sale will be reported to you (but not to the IRS) on a settlement sheet; use that information to calculate your capital gains.
If you have a gain from the sale of your home (meaning your primary residence, not a vacation home), you may qualify to exclude all or part of the gain at tax time up to a maximum of $250,000 for individual taxpayers and $500,000 for married taxpayers. Generally, you must have owned and used your home as your main home for at least two years out of the five years prior to the sale. If you lived in the home for less than two years, you may still be able to exclude some of the gain, but it will be a reduced amount.
You'll want to keep good records of the cost of your capital assets as well as the date that you purchased or otherwise acquired them. The date matters for calculating what kind of gain you have. If you own an asset for more than one year before sale or other disposition, your capital gain or loss is said to be "long term." If you own an asset for less than one year before sale or other disposition, your gain or loss is said to be "short term."
Long term capital gains are subject to a more favorable tax rate than short term capital gains. For 2010, the rates for long term gains start at 0% for those in the lowest income tax bracket and top out at 15%. The rates for short term gains start at 10% and top out at 35%. Special rates apply for collectibles and the sale of certain small business stock.
Capital losses may be used to offset capital gains, with an important exception: Losses from the sale of personal use property, such as your home or car, are never deductible. If your losses exceed your gains, you can claim up to $3,000 ($1,500 if you are married filing separately) as a deductible loss on your tax return. If your loss exceeds that amount, you can carry it forward and use it in future tax years.
Calculating and reporting your gain or loss on the most common capital assets isn't difficult so long as you have good records (or a great financial adviser). For more complicated situations, such as selling heavily-depreciated rental real estate, you'll want to consult with your tax adviser.