Capital Gains Tax (CGT) Explained

Nearly every item an individual possesses for their personal use, or investments they might own, is considered a capital asset. Familiar examples include a home, cars, furniture, and shares of stocks and bonds that are held in a personal account.

When an individual sells a capital asset for more than they paid for it, they have a capital gain. If an individual sells the asset for less than they paid for it, they have a capital loss. But there are some very important exceptions to these rules that are discussed later on. This includes assets such as inherited property, cars, and homes.

There are two types of capital gains and losses: long-term and short-term. If an asset is owned for more than one year before it's sold, the capital gain or loss is considered long-term. The gain or loss on assets held for twelve months or less are considered short-term.

A net capital gain is the amount by which all the long-term capital gains exceed any-short term capital losses. The ATRA raised the highest tax rate on a net capital gain to 20% in 2013; however, there are three important exceptions to this rule that remained unchanged:

• Any net capital gains from selling Section 1250 real property, due to depreciation, is taxed at a maximum 25% rate.

• Any taxable gain from qualified small business stock is taxed at a maximum 28% rate.

• Gains from selling collectibles, such as art or coins, are taxed at a maximum 28% rate.

If an individual experiences a capital loss, it can be claimed up to a maximum of $3,000, or $1,500 if married, filing separately. If the loss exceeds these maximums, it can be carried forward into later years for tax reporting purposes.

Starting back in 2006, capital gains tax law had a sunset provision, and unless approved by congress, was scheduled to revert back to the previous rates of around 20% in effect prior to 2003. The American Taxpayer Relief Act of 2012 made several important changes to the treatment of capital gains, and eliminated the sunset provision, adding stability and permanence to these rules:

• Income Thresholds: individuals in the 10% and 15% tax brackets will pay 0% on gains from eligible dividends and most capital gains.

• Qualified Dividends: income received will be taxed at the same rate as long-term capital gains.

• Tax Rate: individuals in the 25%, 33% and 35% federal income tax brackets will pay 15% on capital gains, while taxpayers in the 39.6% bracket will pay 20%.

Essentially, there are now three tax rates that apply to long-term capital gains. Individuals in the 10% and 15% federal income tax brackets pay 0%, while those in the 39.6% bracket pay 20%; all other taxpayers owe 15%. Short-term capital gains are taxed at an individual's "normal" incremental tax rate.

Starting in 2013, taxpayers above certain income thresholds will also pay a 3.8% Medicare tax on investment income, thereby increasing the effective rate on capital gains to 23.8% (20% + 3.8%) for some taxpayers.

There are several very important exclusions from capital gains that are worth mentioning. An individual can exclude up to $250,000, and married couples filing jointly $500,000, of any capital gains realized on the sale of a home or what is known as real property. This exclusion applies if the property is used as the primary residence for at least two out of the prior five years.

In addition, if an individual realizes both a capital gain and a capital loss in the same tax year, the loss can be used to offset a gain. This is one of the reasons many taxpayers sell investments that have lost value at year's end. The capital loss will help to offset capital gains on other investments.

Finally, the tax law allows individuals to defer their capital gains tax during a 1031 exchange of property, during an installment sale, or when they're involved in the formation of a charitable trust. These particular matters are best discussed with an attorney familiar with the intricacies of tax law.