TAXES > Individuals > Gross Income > Capital Gains or Losses (Schedule D)

Capital Gains or Losses

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.