Capital gain
In finance, a capital gain is profit that results from the sale or exchange of a capital asset over its purchase price. If the price of the capital asset has declined instead of appreciated, this is called a capital loss. Capital gains occur in both real assets, such as property, as well as financial assets, such as stocks or bonds. For equities, according to each national or state legislation, a large array of fiscal obligations must be respected regarding capital gains, and taxes are charged by the state over the transactions, dividends and capital gains on the stock market. However, these fiscal obligations may vary from jurisdiction to jurisdiction because, among other reasons, it could be assumed that taxation is already incorporated into the stock price through the different taxes companies pay to the state, or that tax free stock market operations are useful to boost economic growth.
U.S. tax ramifications
Under the Internal Revenue Code section 1222, gain or loss from sale or exchange of a capital asset is a capital gain or loss. Per IRS Tax Topic 409, "Almost everything you own and use for personal or investment purposes is a capital asset. Examples are your home, household furnishings, and stocks or bonds held in your personal account." If a person sells a capital asset for more than he or she paid for it, the gain is taxable. However, for personal-use capital assets, such as a personal automobile, a capital loss is not deductible.
Long term and short term
Generally, appreciated capital assets sold by an individual after being held more than one year (long-term capital gain) will be taxed at a maximum rate of 15%. For taxpayers earning less than $15,000 annually the tax rate on long-term capital gains is only 5% and will be 0% after 2008. For the sale of collectibles and small business stock, the rate of taxation for individuals is a maximum of 28%. Appreciated capital assets that are sold by individuals after being held less than one year (short-term capital gain) will be taxed as ordinary income, which rises as high as 39.6% in the U.S. progressive tax system.[1] Capital gains by entities taxed as corporations do not receive preferential treatment, and are taxed at a maximum rate of 35 percent.[2]
Realized vs. unrealized
Capital gains can be either realized or unrealized. Realized capital gains occur when the actual sale or exchange of the asset returned more money than the purchase price (as adjusted for depreciation and other factors). A capital gain is considered unrealized, or potential, where the asset has not yet been sold but the asset has appreciated in value (generally, beyond its original cost).
In the United States, unrealized capital gains are not generally subject to income tax. That is, the tax is not incurred until the asset is sold or otherwise disposed of. Capital gains that are realized (and unrealized gains treated as realized under the special rules discussed above) are generally subject to tax, unless some provision of the code provides that those gains need not be currently recognized for tax purposes. Such provisions include, for example, an exclusion from gross income for the first $250,000 (or $500,000 in the case of married couples filing jointly) of capital gain realized on the sale of a principal residence.[3]
Capital loss offset
In taxation in the United States, capital gains are subject to capital gains tax. If a taxpayer has incurred capital losses in the same year as he has realized capital gains, he can offset the gains against the losses to reduce his taxable income. If the capital losses exceed the gains gains, up to $3,000 of the excess capital losses may be deducted against ordinary income (i.e., income other than capital gains) each year. If the taxpayer has a total net loss that is more than the $3,000 yearly limit on net capital loss deductions, the taxpayer can carry over the unused part to the next year and treat the loss as if it had been incurred during that next year.[4] When a loss is carried over, it retains is character as long term or short term, as applicable. A long-term capital loss carried to the next tax year will reduce long-term capital gains (if any) actually realized during that year before being used to reduce that year's short-term capital gains (if any). If part of the loss is still unused, the taxpayer may carry it over to later years until it is completely used up, or until the death of the individual who incurred the loss.
Sale of principal residence
A capital gain on the sale of a principal residence is afforded special treatment for Federal income tax purposes. Married sellers of a principal residence may generally exclude up to $500,000 of gain ($250,000 of gain in the case of single individuals) from gross income, provided the real estate was used as the sellers' primary residence for at least two years during the five year period ending with the date of the sale.
Seven Pillars of capital gain treatment
Seven Pillars of Capital Gain Treatment5 for deciding if properties were held for investment purposes or primarily for sale to customers in the ordinary course of his trade or business and therefore warranted capital gains treatment under I.R.C. §§ 1201, 1202.
(1) the nature and purpose of the acquisition of the property and the duration of the ownership;
(2) the extent and nature of the taxpayer's efforts to sell the property;
(3) the number, extent, continuity and substantiality of the sales;
(4) the extent of subdividing, developing, and advertising to increase sales;
(5) the use of a business office for the sale of the property;
(6) the character and degree of supervision or control exercised by the taxpayer over any representative selling the property; and
(7) the time and effort the taxpayer habitually devoted to the sales.
Qualifications for the capital gains tax rates
To qualify for the preferential capital gains tax rates of Internal Revenue Code section 1(h) (Maximum Capital Gains Rate), an individual must have a “net capital gain,” which is defined in §1222(11) as the excess of net long-term capital gain over ‘net short-term capital loss.5 According to Internal Revenue Code section 1222(1)-(4), to have a net long-term capital gain, the taxpayer must have held the capital asset for more than one year.6
Determining appropriate tax rate based on nature of capital gains
Not all capital gains are taxed at the same rate. Four separate tax rates are available for capital gains. The rate applicable to a particular gain depends on both the total income of the taxpayer and the nature of the capital gain.[5]
(1) The 5% Rate for Adjusted Net Capital Gain of Lower-Income Taxpayers: A taxpayer with an income of $31,850 (currently the margin of the 15% tax bracket) or less (including amount of capital gain) will see his capital gains taxed at a 5% rate. [6]
(2) The 15% Rate for Remaining Adjusted Net Capital Gain: Once the total income of the taxpayer exceeds $31,850 (the margin of the 15% tax bracket), the portion of capital gains that make up the excess will be taxed at a rate of 15%. Any capital gains below the $31,850 line are still taxed at 5%, and the remainder of the capital gain that is over that line is subject to the 15% rate. [7]
(3) The 25% Rate for Unrecaptured Sec. 1250 Gain: A flat 25% capital gains rate is imposed on so-called "unrecaptured 1250 gain". This type of gain occurs only where net capital gain partly consists of gain arising from the sale or exchange of depreciable real property used in the taxpayer's business or held for investment. [8]
(4) The 28% Rate for Collectibles and Sec. 1202 Gains: Any capital gains arising from the sale or exchange of collectibles and/or Sec. 1202 stock will be taxed at a rate of 28%. [9]
Preferential History of Capital Gains
1921: Congress limited the tax rate applicable to capital gains held for more than two years to 12.5 percent. The highest marginal rate for ordinary income was 73 percent.7
1934: Congress changed capital gain from a lower rate to a deduction so that the longer a taxpayer held a capital asset, the less the amount of gain was subject to taxation.8
1938: Congress reverted to taxing the entire gain at a preferential rate so while the maximum marginal tax rate on income was 81.1 percent, capital gains were only taxed at 15 percent.9
1942: The highest marginal rate for ordinary income grew to 91 percent and the rate for capital gains grew to 25 percent.10
1969: Congress returned to a deduction scheme, permitting taxpayers to exclude 1/2 their net capital gains. Taxpayers in the 70% bracket could limit their capital gains tax to 35%.11
1978: Congress increased the deduction from 50 to 60 percent, allowing taxpayers in the highest tax bracket to incur a tax of 28 percent on their capital gains.12
1986: The Tax Reform Act of 1986 repealed all preferences for capital gains. The maximum tax rate applicable to ordinary income and capital gains was set at 28 percent.13
1990: Preferential rates for capital gains were restored when the maximum tax rate on ordinary income grew to 31 percent, because capital gains remained taxed at 28 percent.14
1993: The maximum rate applicable to ordinary income grew to 39.6 percent; but capital gains remained taxed at 28 percent.15
1997: Congress reduced capital gains tax rate to 20 percent and gave taxpayers in the 15 percent bracket a capital gains tax rate of 10 percent.16
2003: The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the tax rate for “net capital gain” from 20% to 15% and to 5% for taxpayers in the lower brackets.17
2008: The 5 percent capital gain tax for taxpayers in the lower brackets will be reduced to zero.18
2011: Absent further action by Congress, the capital gains rates will revert to their pre-2003 levels.19
Policy Reasons For and Against Preferential Rates for Capital Gains
Traditionally preferential rates for long-term capital gains were justified on the grounds of inflation, because it was thought that a preferential rate for long-term capital gains was necessary to accommodate for the hardships of taxing gains due to inflation instead of real economic growth.20 A second rationale was that when the taxpayer sells the capital asset, all of the gains from the asset is bunched into the year of sale, so the taxpayer does not recognized this appreciation as it accrues and will be at a greater risk that the gain will be taxed at a higher rate.21 Another rationale is that keeping a low tax rate for capital gains will stimulate savings and investment by taxpayers.22 Finally, there is a belief that the lower rate may give a taxpayer an incentive to sell the capital asset instead of holding it until death so that they can receive a stepped-up basis for the taxpayer’s beneficiary.23
One policy opposition to preferential rates for long-term capital gains revolves around a belief that a better way exists to account for inflation.24 Opponents of preferential rates for capital gains state that since taxpayers usually control the timing of the realization event giving rise to the gain, bunching is far less of a justifiable rationale and that a lower tax rate for long-term capital gains gives an incentive for taxpayers to sell capital assets which may not be beneficial.25 In addition, some opponents believe the preferential rates for capital gains widen the income inequality gap. At a fundraiser for presidential hopeful Hillary Clinton, Warren Buffet questioned a U.S. tax system that permits him to pay a lower tax rate than his secretary.26 Buffet received preferential rates for much of the $46 million that he made last year and was taxed at 17.7 per cent. His secretary, who made $60,000, was taxed at 30 per cent.27
Other Countries where Capital Gains are taxable
There is currently no capital gains tax after a holding period of more than one year for equities. However, 10% of tax is applied for short term equity-shares gain. This is applicable only for transactions that attract Securities Transaction Tax (STT).
As of 2006, shares / equities are considered long term capital, if the holding period is one year or more. Long term capital gains are taxed either at 10% of earnings or 30% of (earnings - deduction based on inflation index).
Short term capital gains are taxed just as any other income and they can be negated against short term capital loss from the same business.
Many other capital investment (home, buildings, real estate, bank deposits) are considered long term if the holding period is 3 or more years.
- India [1]
- United Kingdom [2]
- People's Republic of China
- South Africa
- Australia
- France
- Canada
- Indonesia
- Spain
Notes
5. United States v. Winthrop, 417 F.2d 905, 910 (5th. Cir. 1969)
6. Samuel A. Donaldson, Federal Income Taxation of Individuals: Cases, Problems and Materials, 2nd Edition (St. Paul: Thomson/West, 2007), 510.
7. Id.
8. Id. at 138-140.
9. Id.
10. Id.
11. Id.
12. Id.
13. Id.
14. Id.
15. Id.
16. Id.
17. Id.
18. Id.
19. Id.
20. Id.
21. Id.
22. Id.
23. Id.
24. Id.
25. Id.
26. http://business.timesonline.co.uk/tol/business/money/tax/article1996735.ece.
27. Id.
References
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- For further information on U.S. capital gains, go to Tax Topic 409 at the IRS: http://www.irs.gov/taxtopics/tc409.html and Publication 550 at http://www.irs.gov/publications/p550/ch04.html#d0e11041