What is Capital Gains?
This post will provide a Capital Gains 101 overview. There are many special rules that apply to how you acquire your capital assets, how long you hold them, and how different assets are treated. I am not a tax lawyer, CPA, or other tax professional. What I offer here is basic information for educational purposes only. The Internal Revenue Service (IRS) provides several useful resources. For your convenience, I have added links throughout this post to some of those IRS resources. I encourage you to read them. In addition, you are advised to contact a tax accountant or a tax lawyer for specific advice.
- Did you know that almost everything you own and use for personal or investment purposes is a capital asset?
- Do you know how to define cost basis?
Capital Gains and Capital Loss Defined.
The Internal Revenue Code (the “IRC”) defines capital gain and loss as generally the gain or loss realized from the sale or disposition of a capital asset. The IRC describes many exceptions to this rule, which is why it is important to consult with a tax professional about your specific case.
Almost everything you own and use for personal or investment purposes is a capital asset. Some examples may include land, buildings, jewelry, antiques, household furnishings, automobiles, business equipment, copyrights, trademarks, patents, franchises, stock, and bonds.
The cost basis or basis is the purchase price of the asset in question. This price includes the actual price you paid plus any expenses you paid to acquire, produce, or settle the capital asset. Some examples of expenses are the following:
- Sales tax.
- Real estate taxes, if the buyer is required to pay.
- Freight costs.
- Installation and testing.
- Interest on loans to purchase asset.
- Excise taxes.
- Legal and accounting fees.
- Recording fees.
- Commissions owed to an agent.
- Certain settlement and closing costs.
- Other costs related to buying or producing property.
Intangible Capital Assets.
If your capital asset is intellectual property, such as a patent, copyright, or trademark, the basis generally includes the cost to purchase, develop, or create the asset.
Patents. The cost basis of a utility, plant, or design patent is what it costs to develop it. That may include research and experimental expenditures, drawings, working models, attorneys’ fees, USPTO registration fees.
Copyrights. For authors, the cost basis will usually include the cost of securing the copyright, plus copyright fees, attorneys’ fees, clerical assistance, and the cost of plates that remain in your possession.
Franchises, trademarks, and trade names. If you purchase a franchise, trademark, or trade name, the cost basis is what you paid for the asset, unless you were able to deduct your costs as a business expense.
Capital Gain or Loss.
When you sell your capital asset, the difference between what you paid and the price you sell it for will be a capital gain or a capital loss.
Let’s suppose you purchase a piece of land for $100,000 in 2000 and sell that land in 2022 for $500,000. You have a capital gain of $400,000. You will likely have to pay a capital gains tax on $400,000 unless your accountant can come up with some creative tax deductions. On the other hand, suppose you purchase that same piece of land for $100,000 in 2000 and sell that land in 2022 for $50,000, because of a significant downturn in the market. You have a capital loss of $50,000. You will likely have no capital gains tax to pay.
Long-term vs Short-term Capital Gains.
Capital gains are either long-term or short-term capital gains. Generally, if the asset is held for over a year before you dispose of it, your capital gain or loss is long-term. If the asset is held for a year or less, your capital gain or loss is short-term. As with everything tax and legal related, there are exceptions.
Capital Gains Tax vs Ordinary Income Tax.
Why does this matter? The classification will determine the amount of tax you pay. Generally, capital gains tax treatment is more favorable than ordinary income tax treatment. One reason for this is that the IRS wants to encourage people to purchase capital assets and hold them for longer periods of time. Therefore, assets held for over a year enjoy more favorable tax treatment than assets held for a year or less.
Carry-over Basis and Stepped-up Basis.
What is carry-over basis and how does it differ from stepped-up basis? The carry-over basis is applied when the person giving the gift of a capital asset does so during their lifetime. On the other hand, a stepped-up basis is applied when the asset is passed through inheritance after the person giving the asset has passed away.
Example of Carry-over Basis:
Suppose you purchase one acre of unimproved real estate in 2000 for $10,000 and in 2019 you gift that piece of land to your son. Generally speaking, your $10,000 basis is carried over to your son, which means he owns property valued at $10,000. But suppose 9-months later he sells the property for $100,000. His profit (or gain) is $90,000. He will likely have to pay tax on his short-term capital gain of $90,000.
Example of Stepped-up basis:You purchase land in 2000 for $10,000. You leave that piece of property to your son in your will. At the time of your death, the fair market value of the land is now $100,000. Your son’s new basis is $100,000. If he then decides to sell the property for $100,000 cash the day after you die, he would likely have no capital gains tax to pay. But, if he sold the property 2-years after you died for $400,000, he would likely have to pay long-term capital gains tax on his $300,000 gain.
Feel free to download your complimentary Capital Gains 101 download defining the basics: https://mailchi.mp/fward/capitalgains