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TAXES
> Individuals > Gross
Income > Capital Gains or Losses (Schedule D)
The
tax treatment of capital gains and losses depends on whether the gains
and losses are long-term or short-term and on whether the taxpayer is
a corporation or not. For noncorporate taxpayers, the maximum tax rate
on net long-term capital gains is lower than the top rate on ordinary
income. The maximum tax rate on long-term capital gains depends on the
type of capital asset sold, and the taxpayer's marginal tax rate (the
top rate of tax on the person's ordinary income). The long-term capital
gains of corporations, and the short-term gains of corporations and of
noncorporate taxpayers, are taxable at the same rates as their ordinary
income. The deduction for capital losses is limited, but unused capital
losses may be carried over to the next tax year.
The
main features of the income tax treatment of capital gains and losses
are:
Short-term capital gains and losses are netted, long-term capital gains
and losses are netted, and then long- and short-term are netted with each
other. Further netting may be required if the taxpayer has long-term capital
gain subject to differing maximum rates of tax. If there is a net capital
gain (excess of net long-term capital gain over net short-term capital
loss), it generally will be more favorably taxed than ordinary income.
The maximum tax rate depends on whether the net capital gain is adjusted
net capital gain, taxed no higher than 20%, collectibles gain or section
1202 gain, taxed no higher than 28%, or unrecaptured section 1250 gain,
which is taxed no higher than 25%. Section 1231 nets gains and losses
to arrive at a net of long-term capital gain or ordinary loss. Recapture
provisions restrict the possibility of converting ordinary income into
capital gains via cost recovery or depreciation.
Capital gains and losses are the gains and losses from sales or exchanges
of capital assets. But capital gain or loss treatment also applies to
gains in certain transactions involving assets that are not capital assets
(such as depreciable property used in business). Designation of a loss
as capital (or ordinary) does not make it deductible. An individual can
only deduct losses incurred in business, transactions for profit, casualty
or theft. Thus, a loss on sale of a personal residence is a nondeductible
capital loss. Capital gains and losses are reported on Schedule D (Forms
1040, 1041, 1065, 1120, 1120S).
If a capital asset is held for not more than the short-term holding period
, the gain or loss from its sale or exchange is short-term. If held for
more than the short-term holding period, gain or loss is long-term. Short-term
capital gains and losses are netted to get net short-term capital gain
or net short-term capital loss. Long-term capital gains and losses are
netted to get net long-term capital gain or net long-term capital loss.
There is a further netting if one group shows a loss and the other a gain:
A net short-term gain is taxable (both for noncorporate and corporate
taxpayers) at the same rate as ordinary income. If net long-term capital
gains exceed net short-term capital losses, the excess is net capital
gain, taxed at statutory rates. The various maximum tax rates for net
capital gains of noncorporate taxpayers (20%/10%, 25%, and 28%) are implemented
by means of the following formula. In applying the formula, the netting
rules apply. For a noncorporate taxpayer with net capital gain for any
tax year the tax for that year cannot be more than the sum of the items
described in (1) through (5) below.
(1) A tax, computed at the rates and in the same manner as if there was
no maximum capital gains rate, on the greater of (a) taxable income reduced
by the net capital gain (modified as explained below), or (b) the lesser
of the amount of taxable income taxed at a rate below 28%, or taxable
income reduced by the adjusted net capital gain (defined below).
(2) 10% of so much of the adjusted net capital gain (or taxable income,
if less) as does not exceed the excess (if any) of (a) the amount of taxable
income which would (without regard to the rules for determining the maximum
tax on capital gain) be taxed at a rate below 28%, over (b) the taxable
income reduced by the adjusted net capital gain. (3) 20% of the adjusted
net capital gain (or taxable income, if less) in excess of the amount
on which a tax is determined under (2) above. (4) 25% of the excess (if
any) of (a) the unrecaptured section 1250 gain (or, if less, the net capital
gain), over (b) the excess (if any) of the sum of the amount on which
tax is determined under (1), above, plus the net capital gain, over taxable
income. (5) 28% of the amount of taxable income in excess of the sum of
the amounts on which tax is determined under paragraphs (1) through (4)
above.
In applying the above formula, net capital gain for any tax year is reduced
(but not below zero) by the amount which the taxpayer takes into account
as investment income under Code Sec. 163(d)(4)(B)(iii). The above computations
are reflected in Schedule D, Form 1040.
Unrecaptured section 1250 gain, taxed at a maximum rate of 25%, is the
excess (if any) of (1) the amount of long-term capital gain which is not
otherwise treated as ordinary income, and which would be treated as ordinary
income if Code Sec. 1250(b)(1) recapture applied to all depreciation (rather
than only to depreciation in excess of straight line), and the applicable
percentage under Code Sec. 1250(a) were 100%, over (2) the excess (if
any) of the amount of losses taken into account in computing 28% rate
gain over the amount of gains taken into account in computing 28% rate
gain. Depreciation on real property under MACRS must be deducted using
the straight-line method. Thus, any gain on the sale or exchange of such
property attributable to depreciation will be unrecaptured section 1250
gain if held for more than one year.
The 28% rate gain is the amount of net gain attributable to (1) collectibles
gains and losses, (2) an amount of gain equal to the gain excluded from
gross income on the sale of certain small business stock under section
1202, (3) the net short-term capital loss for the tax year, and (4) the
long-term capital loss carryover to the tax year. As a result of the definition
of 28% rate gain, a long-term capital loss carryover from an earlier tax
year will always be used first to offset 28% rate gain.
If any amount is treated as ordinary income under Code Sec. 1231(c) (relating
to capital gain/ordinary loss treatment of gains and losses from the sale
or exchange, or involuntary conversion, of property used in the trade
or business and certain property held for the production of income), that
amount must be allocated among the separate categories of net section
1231 gain in the manner to be prescribed by forms or regulations. According
to IRS, gain recharacterized under this rule first consists of any net
section 1231 gain in the 28% group, then any section 1231 gain in the
25% group, and then any net section 1231 gain in the 20% group.
Gain or loss from the sale or exchange of a noncompensatory option to
buy or sell property is considered a gain or loss from the sale or exchange
of a capital asset if the optioned property is (or would be if acquired)
a capital asset in the taxpayer's hands. If the holder of an option incurs
a loss because he fails to exercise the option, the option is considered
to have been sold or exchanged on the date it expires. There are no tax
consequences to the buyer or writer of an option until the option is exercised,
otherwise closed out or lapses. The holder treats the premium paid as
a nondeductible capital expenditure at the time of payment. The premium
is not included in income of the writer at the time of receipt. The premium
received by the writer for granting a "put" or "call" option that is not
exercised ("lapses"), so that the writer simply keeps the money, is generally
treated as ordinary income, and gain or loss to the writer on repurchase
of an option ("closing transaction") is also generally ordinary. However,
gain or loss to a nondealer from a lapse or closing transaction involving
options in stocks, securities, commodities or commodity futures is treated
as short-term capital gain or loss. Where a put is exercised, the premium
received by the writer for granting the option is deducted from the option
price for the property in determining the net basis to the writer of the
property purchased. The holder deducts the premium from the amount received
from the writer, in computing the gain or loss realized on the sale. Where
a call is exercised, the premium received by the writer (i.e., seller)
for granting the option is added to the sale proceeds received. This is
included in the holder's (buyer's) basis for the property. When the put
or call is bought from the original holder (or his assignee), the buyer
is treated as a holder, and the amount paid by him to the original holder
is likewise treated as a premium. However, the original holder is not
treated as a writer, and must include that premium in his amount realized
upon disposition of the option. Thus, if a holder (other than a dealer)
of a put or call option on publicly traded stock closes out a position
by selling the option on an exchange, the gain or loss is a capital gain
or loss. A "straddle" option combines a put and a call. For example, the
writer agrees to buy a stated number of shares of stock within a definite
period at a specified price (a put) and simultaneously agrees to sell
a like number of shares of the same stock, at the same price, within the
same time (a call). For this, the buyer of the straddle pays the writer
a premium. The writer must allocate a single premium received between
the put and the call options on the basis of their relative market values
at the time the straddle is issued or on any other reasonable and consistently
applied basis. IRS may issue whatever regs may be necessary or appropriate
to carry out the purposes of the constructive sale rules. Under this authority,
IRS may treat as constructive sales certain transactions that have substantially
the same effect as those such as short sales, offsetting notional principal
contracts and futures or forward contracts to deliver the same or substantially
similar property, namely those that have the effect of eliminating substantially
all of the taxpayer's risk of loss and opportunity for income or gain.
In a short sale, an investor sells a security for delivery in the future.
The short seller may meet his obligation to deliver by buying the security
on the delivery ("closing") date. If the security has declined in value
by the time he closes or covers the sale, he has a gain equal to the price
at which he sold minus his cost; if the value has increased, his purchase
price is higher than the sale price, and the short seller has a loss.
The nature of the gain or loss on a short sale depends upon the nature
of the property used to close the short transaction. If the property used
to close the short sale is a capital asset in the hands of the short seller,
the gain or loss on the transaction is capital gain or loss. Where the
property used to close the short sale is a capital asset, the period the
taxpayer held the property determines whether the gain or loss is long
or short term, unless certain limits apply. Entering into certain short
sales may result in a taxpayer recognizing gain under the constructive
sale rules. Under those rules, a taxpayer generally is treated as having
made a constructive sale of an appreciated financial position if the taxpayer
enters into a short sale of the same or substantially identical property.
Loss on the sale, exchange or worthlessness of Section 1244 ("small business")
stock is deductible, within limits, as an ordinary loss, even though gain
on the stock is capital gain. This ordinary deduction is available only
to individuals, and only if the individual (or a partnership) was the
original purchaser. Transferees of these original purchasers do not qualify.
The aggregate amount of the ordinary loss is limited to $50,000 on separate
returns and $100,000 on joint returns each year. Spouses may deduct the
$100,000 maximum in a joint return even if only one spouse owned the stock.
A loss on qualifying Section 1244 stock is deductible as an ordinary loss
attributable to the shareholder's business. As such, the loss is deductible
in full from gross income and may give rise to a net operating loss. Losses
exceeding the limits must be treated as regular capital losses. To qualify
as Section 1244 stock, all of the following tests must be met: (1) the
stock must be stock (it must be common stock, nonconvertible into other
securities, if issued before July 19, 1984), voting or nonvoting, of a
domestic corporation. (2) the stock must have been issued for money or
other property, other than stock, securities or services. But stock issued
for the cancellation of corporate debt (that was not evidenced by a security
or issued for services) does qualify. (3) the issuing corporation must
have met a test in which it shows that over 50% of its receipts were from
business operations. (4) the stock must have been issued by a domestic
"small business" corporation. Claim the ordinary loss on Form 4797 (attached
to Form 1040). No information statement is required to be filed with the
return but records must be maintained to establish a loss and whether
the stock qualifies as Section 1244 stock. A small business corporation
is one if at the time the stock is issued its capital receipts do not
exceed $1,000,000 (Special designation rules must be met for stock issued
in a year capital receipts do exceed $1,000,000). Capital receipts are
the aggregate amounts of money and other property received by the corporation
for stock, as a contribution to capital, and as paid-in surplus. This
includes amounts received for the Section 1244 stock and for all stock
issued previously. A noncorporate taxpayer may exclude 50% of gain on
the disposition of qualified small business stock (QSBS) issued after
August 10, 1993 and held over five years. This 50% exclusion is allowed
only to taxpayers other than corporations, i.e., individuals, trusts and
estates. For each corporation in which taxpayer invests, the total amount
of gain eligible for the 50% exclusion for a tax year may not exceed the
greater of: (1) $10,000,000 ($5,000,000 for married filing separately),
reduced by taxpayer's total gain on dispositions of the corporation's
stock that he took into account in earlier years. The amount of eligible
gain is allocated equally between spouses who file jointly, to apply this
limit to later years, or (2) ten times the aggregate adjusted bases of
any of the corporation's QSBS that taxpayer disposed of during the year.
For this purpose, the adjusted basis of any stock doesn't include any
additions to basis after the date it was originally issued, or any reductions
for SSBIC rollovers. The taxpayer must hold the QSBS for more than five
years before the sale or exchange to exclude 50% of the gain. The exclusion
is denied for any gain from the sale of QSBS if taxpayer or any related
person held an offsetting short position with respect to the stock anytime
before the five-year holding period requirement is met. The exclusion
also is denied where the corporation redeems stock from taxpayer or a
related person during certain periods, or buys its own stock in excess
of certain amounts during specified periods. Additional rules apply where
pass-through entities hold the stock. Qualified small business stock is
any stock in a C corporation which is originally issued after August 10,
1993 if: (1) as of the date of issuance, the corporation is a qualified
small business, i.e. a domestic C corporation whose total gross assets
(treating all members of the same parent-subsidiary controlled group as
one corporation) at all times after August 10, 1993 and before the issuance,
and immediately after the issuance (taking into account amounts received
in the issuance), do not exceed $50,000,000, and that meets certain reporting
requirements (2) the taxpayer claiming the exclusion acquired the stock
at its original issuance for money or other property (not stock) or as
compensation for services provided to the corporation, and (3) during
substantially all of taxpayer's holding period for the stock, the corporation
is a C corporation (other than certain excluded corporations) and meets
an active business test. An SSBIC meets the active business test.
The length of time that a capital asset is held before its sale or exchange
determines whether the proceeds from the sale or exchange are taxable
as long-term gain or loss or as short-term gain or loss. The length of
time an asset is held is also crucial in qualifying for Section 1231 (capital
gain/ordinary loss) treatment. Holding a capital asset for the short-term
holding period (one year or less) results in short-term capital gain or
loss on the sale or exchange of that asset. Holding a capital asset for
the long-term holding period (more than one year) results in long-term
gain or loss on the sale or exchange of that asset. For commodity futures,
the holding period is more than six months. This applies to futures transactions
in any commodity subject to the rules of a board of trade or commodity
exchange.
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