Q: Tax Playa, I have a large capital loss on some stock sales (about $10,000). Can I deduct this off my taxes?
Chris, Falls Church VA
A: The federal government is a full partner in your capital gains (sales price minus cost for an asset) if you have a profit. However, you can only deduct $3000 per year (with rollover) of net capital losses.
For more on capital gains and losses, the best resource is to consult the IRS Instructions for Form 1040, Schedule D (Capital Gains and Losses).
Capital gains are profits that you realize from the sale of assets you hold for investment. Common examples of capital assets include stock and mutual fund shares, depreciable property, real estate, intellectual property, and commodities.
A gain is realized if, upon selling the asset, you receive more than the asset's adjusted basis. For example, a stock share you bought for $8 and sold for $10 has a $2 capital gain. Conversely, a stock you bought for $8 and sold for $6 has a $2 capital loss.
The basis of property is generally its cost minus any depreciation you claimed, plus any improvements or costs you have put into it.
Tax law treats capital gains differently based on the holding period of the asset. A capital gain from an asset held less than one year is taxed as ordinary income (the same as anything else). A capital gain from an asset held more than one year benefits from lower capital gains tax rates.
Long-term capital gains on the sale of your home benefit from a special exclusion with its own set of rules. Put very simply, if you sell your home after less than a year, you pay ordinary income tax on the gain. If you sell your home after one year or more, you pay capital gains tax on the gain. If you sell your home after two or more years, you can exclude up to $250,000 of the gain ($500,000 for married couples) and pay the lower capital gains tax rate on the rest.
Mutual funds you may own shares of do not pay income tax themselves. Rather, any capital gains the fund may generate by buying and selling stocks and bonds is passed along to you ratably. The good news is that capital gain distributions from a mutual fund are always considered long-term capital gains, and therefore qualify for the lower rates.
Depreciation on a sold asset must be recaptured. If the asset is personal property (machines and furniture, generally), the depreciation recapture is taxed as ordinary income (since the depreciation deduction was taken against ordinary income). However, depreciation recapture on the sale of real estate qualifies for a lower capital gains tax rate, detailed below.
Sale of an interest in a partnership is also subject to capital gains tax. Within the basis of the partnership may be differing items, including depreciation recapture, etc. This can get messy.
Capital losses are disallowed for personal use property, sales to family members or controlled corporations, and certain situations involving estates and trusts.
One thing to be concerned about with capital losses is not violating the "wash sales" rule. Any loss is disallowed under this rule if a share of a stock or mutual fund is sold at a loss, and within 30 days before or after the sale, you acquire substantially identical shares. This is to prevent harvesting losses via day trading.
Capital losses are limited to $3000 (on net) per year. Any unused capital losses roll over to future years. Thus, the federal government will tax all of your gains, but force you to only slowly realize your losses. A special rule exists for losses of small business stock (this limit is $50,000 per year).
Long-term capital gains are taxed at favorable rates (relative to ordinary income). The rates differ based on the type of capital gain. Below are the rates on long-term capital gains:
28%: Collectibles such as artwork
25%: Depreciation recapture on real estate
15%: Regular long-term capital gains rate
14%: Gain from small business stock held longer than five years (after 50% exclusion)
5%: Long-term capital gain for taxpayers in 15% or lower marginal ordinary income bracket
(this goes to 0% in 2008 and 2009)