When many people hear the term capital gains or capital losses, their eyes glaze over and they drift into a world uncomplicated by complex tax issues. However, capital gains and losses are actually not as confusing as you have probably been led to believe. In fact, during tax preparation, this may be one of the simpler aspects of filing.
Basically, capital gains and losses describe the increase or decrease in the amount you sell an item for compared to the amount you paid for it. For example, if you buy a rental house for $100,000 and sell it for $110,000, you have received a capital gain of $10,000, based in this information alone.
For the most part, everything you own personally or for investment purposes is a capital asset; however, you may not claim losses on all property, such as your personal home or vehicles.
There are two types of gains and losses. They are categorized as long-term or short-term. Holding an asset for one year or more is considered long term, holding less than one year is considered short term.
The term you hold property for determines how it is taxed. Property held for less than one year is taxed as regular income. This may be as high as 35%, depending on your tax bracket, and is considerably higher than the long-term holding rate. Long-term rates are 5%, 15%, 25%, or 28%.
Capital gains losses may be used to offset capital gains. However, if you have losses over the amount of gains, you are limited to claiming $3,000 in a given tax year. You can carry-over losses to future years to still be able to benefit from them. However, even if the loss is limited to $3,000, you are still able to decrease your taxable income, which reduces your tax liability.
There are, however, losses that may not be deductible, such as those on property sold to relatives, transferred from a corporation and someone holding 50% interest in the corporation, as well as between fiduciaries and beneficiaries.
The great news is that there are other ways to avoid or defer paying taxes on a capital gain, if it meets certain criteria. Particularly utilized in real estate, a 1031 exchange is often used to roll income from the sell of one investment into another investment. The purchase of the new property must be completed within 180 days of the sell of the first property. However, for a 1031 exchange to be an option, the investment must be similar in character and nature. This is a way to avoid realizing the capital gain on an asset for potentially a long time. You can keep trading up with 1031 exchanges and not pay the taxes until you stop the cycle and do not buy another property. At this point, you would have to claim the capital gain.