Capital Gains and Dividends: How are capital gains taxed?
Capital gains are profits from the sale of a capital asset, such as shares of corporate stock, a business, a parcel of land, or a piece of art. Capital gains are generally included in taxable income but are often taxed at a lower rate; under current law, for example, most long-term capital gains face a top rate of 15 percent. Complicated rules impose a range of tax rates on different kinds of gains and can make it difficult for taxpayers to calculate their tax liability.
- A capital gain occurs when a capital asset is sold or exchanged at a price higher than its basis (its purchase price plus commissions and the cost of improvements net of depreciation). Similarly, a capital loss occurs when an asset is sold for less than its basis. Gains and losses (like other forms of capital income and expense) are all measured in nominal terms-that is, unadjusted for inflation.
- Capital gains and losses are considered long term if the asset was held for over one year, and short term if held for a year or less.
- Taxpayers in the 10 and 15 percent tax brackets pay no tax on most long-term gains; under EGTRRA provisions, extended through 2012 by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, and taxpayers in higher brackets face a 15 percent rate on long-term capital gains. In 2013, when all the temporary provisions expire, those rates will revert to pre-2001 levels: 10 percent for those in the 15 percent tax bracket or lower and 20 percent for all others. Recaptured real estate depreciation (that is, gains up to the amount of depreciation deductions previously claimed) is taxed at ordinary income tax rates up to a maximum of 25 percent. Gains on art and collectibles are taxed as ordinary income up to a maximum 28 percent rate. The maximum rates apply under both the ordinary income tax and the alternative minimum tax (AMT). The figure shows how the maximum long-term capital gains tax rate has changed over the years.
- Capital losses may be used to offset capital gains and up to $3,000 of other taxable income. The unused portion of a capital loss may be carried over to future years.
- Taxpayers may realize up to $250,000 of gains on their principal residence tax-free. Married taxpayers filing jointly may exclude up to $500,000 from tax.
- The basis for an asset received as a gift equals the donor’s basis. However, the basis of an inherited asset is "stepped up" to the value of the asset on the date of the donor’s death. The step-up provision effectively exempts from income tax any gains on assets held until death. Assets inherited from people who died in 2010 (when the estate tax was repealed) qualified only for a limited step-up of $3 million for gifts made to a spouse plus $1.5 million for gifts made to anyone. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 allowed estates of people who died in 2010 to choose between the 2010 law and the 2011 law, under which heirs get full step-up in basis but the estate is potentially taxable. (See What did the 2001-2010 Tax Acts do to the Estate, Gift and Generation Skipping Transfer Taxes?).Individuals may exclude up to 50 percent of capital gains on stock held for more than five years in a domestic C corporation with gross assets under $50 million on the date of the stock’s issuance.
- C corporations pay the regular corporate rates on the full amount of their capital gains and may use capital losses only to offset capital gains, not other kinds of income.
- Capital gains may face effective tax rates above the statutory rates because of phase-outs in the tax code. For example, taxpayers in the phase-out range of the AMT exemption incur an implicit surtax of 6.5 percent (for taxpayers in the 26 percent AMT bracket) or 7 percent (for taxpayers in the 28 percent AMT bracket).
- I you find this description mind-numbingly complex, you have captured the essence of capital gains taxation.