Capital gains tax in the United States
Encyclopedia
In the United States, individuals and corporations pay income tax
on the net total of all their capital gain
s just as they do on other sorts of income. Capital gains are generally taxed at a preferential rate in comparison to ordinary income
(26 U.S.C. §1(h)). This is intended to provide incentives for investors to make capital investments, to fund entrepreneurial activity, and to compensate for the effect of inflation and the corporate income tax. The amount an investor is taxed depends on both his or her tax bracket
, and the amount of time the investment was held before being sold. Short-term capital gains are taxed at the investor's ordinary income
tax rate, and are defined as investments held for a year or less before being sold. Long-term capital gains, which apply to assets held for more than one year, are taxed at a lower rate than short-term gains. In 2003, this rate was reduced
to 15%, and to 5% for individuals in the lowest two income tax brackets. The reduced 15% tax rate on qualified dividends and long term capital gains, previously scheduled to expire in 2008, was extended through 2010 as a result of the Tax Increase Prevention and Reconciliation Act of 2005
signed into law by President George W. Bush
. This was extended through 2012 in legislation passed by Congress and signed by President Barack Obama
on Dec 17, 2010. As a result:
When the taxable gain or loss resulting from the sale of an asset is calculated, its cost basis
is used rather than its actual purchase price. The cost basis is an adjustment of the purchase price that takes into account factors such as fees paid (brokerage fees, certain legal fees, sales fees), taxes paid (including sales tax
, excise taxes, real estate taxes, etc.), and depreciation
.
The United States is unlike other countries in that its citizens are subject to U.S. tax regardless of where in the world they reside. U.S. citizens therefore find it difficult to take advantage of personal tax haven
s. U.S. law requires reporting of income from those accounts, and failure to do so constitutes tax evasion
.
was introduced, allowing a tax rate of 12.5 percent gain for assets held at least two years. From 1934 to 1941, taxpayers could exclude percentages of gains that varied with the holding period: 20, 40, 60, and 70 percent of gains were excluded on assets held 1, 2, 5, and 10 years, respectively. Beginning in 1942, taxpayers could exclude 50 percent of capital gains on assets held at least six months or elect a 25 percent alternative tax rate if their ordinary tax rate exceeded 50 percent. Capital gains tax rates were significantly increased in the 1969
and 1976
Tax Reform Acts. In 1978, Congress reduced capital gains tax rates by eliminating the minimum tax on excluded gains and increasing the exclusion to 60 percent, thereby reducing the maximum rate to 28 percent. The 1981 tax rate reductions further reduced capital gains rates to a maximum of 20 percent.
The Tax Reform Act of 1986
repealed the exclusion of long-term gains, raising the maximum rate to 28 percent (33 percent for taxpayers subject to phaseouts). When the top ordinary tax rates were increased by the 1990 and 1993 budget acts, an alternative tax rate of 28 percent was provided. Effective tax rates exceeded 28 percent for many high-income taxpayers, however, because of interactions with other tax provisions. The new lower rates for 18-month and five-year assets were adopted in 1997 with the Taxpayer Relief Act of 1997
. In 2001, President George W. Bush
signed the Economic Growth and Tax Relief Reconciliation Act of 2001
, into law as part of a $1.35 trillion tax cut program.
Short-term capital gains are taxed as ordinary income rates as listed above. Long-term capital gains have lower rates corresponding to an individual’s marginal ordinary income tax rate, with special rates for a variety of capital goods.
exempts 100% of the taxes on capital gains for angel and venture capital investors on small business investments if held for 5 years. However, this exemption only applies to shares of stock. It excludes convertible debt and warrants which are major components of most angel and venture capital arrangements. This is a temporary measure that applies to stock bought after September 27, 2010 but before January 1, 2011.
The temporary 100% exclusion of capital gain from the sale of certain small business stock under IRC § 1202 was extended further through 2011 by the H.R. 4853: Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010
as a jobs stimulus http://www.journalofaccountancy.com/Web/20103682.htm http://www.jdsupra.com/post/documentViewer.aspx?fid=7aa573b0-641c-4f87-a5b3-e8aceb48aab9.
In addition, a problem with alternative minimum tax
associated with the sale of company stock was fixed http://www.schwabe.com/showarticle.aspx?Show=12138.
The President’s new budget in year 2011 will propose making permanent the elimination of capital gains taxes on key investments in small businesses, which was passed as a temporary provision in 2010 as part of the Small Business Jobs Act of 2010
the President signed in September. The budget will also propose expanding the New Markets Tax Credit Program
to encourage private sector investment in startups and small businesses operating in lower-income communities. http://www.whitehouse.gov/the-press-office/2011/01/31/white-house-launch-startup-america-initiative
Section 121 provides no benefit if there is a loss on the sale of the property. One is not able to deduct a loss on the sale of one's home.
According to real estate lawyer Robert Bruss, a long commute does not allow a partial exemption in tax to move closer to work. In an article in the Washington Post, Bruss pointed out that bankruptcy of your present employer would likely permit a homeowner a partial use of the $250K / $500K exemption to allow a homeowner to move to a new job in a different city. According to an article in the Washington Post, a taxpayer can move more often to avoid capital gains tax in expensive areas.
against ordinary income, up to $3,000 per year ($1,500 in the case of a married individual filing separately). Any additional net capital loss of the individual can be "carried over" into the next year and "netted out" against gains for that year. Corporations are permitted to carry capital losses back three years to off-set capital gains from prior years, thus earning a kind of retroactive refund of capital gains taxes. After the carryback, a corporation may carry the unused portion of the loss forward five years.
(ensured installment sale), charitable trust
(CRT), installment sale, private annuity trust
(no longer valid), and a 1031 exchange.
is taxed. Similarly, gains that do not even keep pace with inflation are still treated as gains when they are in fact losses http://online.wsj.com/article/SB115983941679680708.html.
Income tax
An income tax is a tax levied on the income of individuals or businesses . Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate...
on the net total of all their capital gain
Capital gain
A capital gain is a profit that results from investments into a capital asset, such as stocks, bonds or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor...
s just as they do on other sorts of income. Capital gains are generally taxed at a preferential rate in comparison to ordinary income
Ordinary income
Under the United States Internal Revenue Code, the type of income is defined by its character. Ordinary income is usually characterized as income other than capital gain...
(26 U.S.C. §1(h)). This is intended to provide incentives for investors to make capital investments, to fund entrepreneurial activity, and to compensate for the effect of inflation and the corporate income tax. The amount an investor is taxed depends on both his or her tax bracket
Tax bracket
Tax brackets are the divisions at which tax rates change in a progressive tax system . Essentially, they are the cutoff values for taxable income — income past a certain point will be taxed at a higher rate.-Example:Imagine that there are three tax brackets: 10%, 20%, and 30%...
, and the amount of time the investment was held before being sold. Short-term capital gains are taxed at the investor's ordinary income
Ordinary income
Under the United States Internal Revenue Code, the type of income is defined by its character. Ordinary income is usually characterized as income other than capital gain...
tax rate, and are defined as investments held for a year or less before being sold. Long-term capital gains, which apply to assets held for more than one year, are taxed at a lower rate than short-term gains. In 2003, this rate was reduced
Jobs and Growth Tax Relief Reconciliation Act of 2003
The Jobs and Growth Tax Relief Reconciliation Act of 2003 , was passed by the United States Congress on May 23, 2003 and signed into law by President George W. Bush on May 28, 2003...
to 15%, and to 5% for individuals in the lowest two income tax brackets. The reduced 15% tax rate on qualified dividends and long term capital gains, previously scheduled to expire in 2008, was extended through 2010 as a result of the Tax Increase Prevention and Reconciliation Act of 2005
Tax Increase Prevention and Reconciliation Act of 2005
The Tax Increase Prevention and Reconciliation Act of 2005 was enacted on May 17, 2006.This bill prevents several tax provisions from sunseting in the near future. The two most notable pieces of the bill are the extension of the reduced tax rates on capital gains and dividends and extension of the...
signed into law by President George W. Bush
George W. Bush
George Walker Bush is an American politician who served as the 43rd President of the United States, from 2001 to 2009. Before that, he was the 46th Governor of Texas, having served from 1995 to 2000....
. This was extended through 2012 in legislation passed by Congress and signed by President Barack Obama
Barack Obama
Barack Hussein Obama II is the 44th and current President of the United States. He is the first African American to hold the office. Obama previously served as a United States Senator from Illinois, from January 2005 until he resigned following his victory in the 2008 presidential election.Born in...
on Dec 17, 2010. As a result:
- In 2008–2012, the tax rate on qualified dividends and long term capital gains is 0% for those in the 10% and 15% income tax brackets.
- After 2012, dividends will be taxed at the taxpayer's ordinary income tax rate, regardless of his or her tax bracket.
- After 2012, the long-term capital gains tax rate will be 20% (10% for taxpayers in the 15% tax bracket).
- After 2012, the qualified five-year 18% capital gains rate (8% for taxpayers in the 15% tax bracket) will be reinstated.
| 2003–2012 | 2013– | ||||||
|---|---|---|---|---|---|---|---|
| 2003–2007 | 2008–2012 | 2013– | |||||
| Ordinary Income Tax Rate | Short-term Capital Gains Tax Rate |
Long-term Capital Gains Tax Rate |
Short-term Capital Gains Tax Rate |
Long-term Capital Gains Tax Rate |
Ordinary Income Tax Rate | Short-term Capital Gains Tax Rate |
Long-term Capital Gains Tax Rate |
| 10% | 10% | 5% | 10% | 0% | 15% | 15% | 10% |
| 15% | 15% | 5% | 15% | 0% | |||
| 25% | 25% | 15% | 25% | 15% | 28% | 28% | 20% |
| 28% | 28% | 15% | 28% | 15% | 31% | 31% | 20% |
| 33% | 33% | 15% | 33% | 15% | 36% | 36% | 20% |
| 35% | 35% | 15% | 35% | 15% | 39.6% | 39.6% | 20% |
When the taxable gain or loss resulting from the sale of an asset is calculated, its cost basis
Cost basis
Basis , as used in United States tax law, is the original cost of property, adjusted for factors such as depreciation. When property is sold, the taxpayer pays/ taxes on a capital gain/ that equals the amount realized on the sale minus the sold property's basis.The taxpayer deserves a tax-free...
is used rather than its actual purchase price. The cost basis is an adjustment of the purchase price that takes into account factors such as fees paid (brokerage fees, certain legal fees, sales fees), taxes paid (including sales tax
Sales tax
A sales tax is a tax, usually paid by the consumer at the point of purchase, itemized separately from the base price, for certain goods and services. The tax amount is usually calculated by applying a percentage rate to the taxable price of a sale....
, excise taxes, real estate taxes, etc.), and depreciation
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
.
The United States is unlike other countries in that its citizens are subject to U.S. tax regardless of where in the world they reside. U.S. citizens therefore find it difficult to take advantage of personal tax haven
Tax haven
A tax haven is a state or a country or territory where certain taxes are levied at a low rate or not at all while offering due process, good governance and a low corruption rate....
s. U.S. law requires reporting of income from those accounts, and failure to do so constitutes tax evasion
Tax evasion
Tax evasion is the general term for efforts by individuals, corporations, trusts and other entities to evade taxes by illegal means. Tax evasion usually entails taxpayers deliberately misrepresenting or concealing the true state of their affairs to the tax authorities to reduce their tax liability,...
.
History of capital gains tax in the U.S.
From 1913 to 1921, capital gains were taxed at ordinary rates, initially up to a maximum rate of 7 percent. In 1921 the Revenue Act of 1921Revenue Act of 1921
The United States Revenue Act of 1921 was the first Republican tax reduction following their landslide victory in the 1920 federal elections. New Secretary of the Treasury Andrew Mellon argued that significant tax reduction was necessary in order to spur economic expansion and restore...
was introduced, allowing a tax rate of 12.5 percent gain for assets held at least two years. From 1934 to 1941, taxpayers could exclude percentages of gains that varied with the holding period: 20, 40, 60, and 70 percent of gains were excluded on assets held 1, 2, 5, and 10 years, respectively. Beginning in 1942, taxpayers could exclude 50 percent of capital gains on assets held at least six months or elect a 25 percent alternative tax rate if their ordinary tax rate exceeded 50 percent. Capital gains tax rates were significantly increased in the 1969
Tax Reform Act of 1969
The United States Tax Reform Act of 1969 was a federal tax law signed by president Richard Nixon in 1969. The largest impact of the act was the creation of the Alternative Minimum Tax, which was intended to tax high income earners otherwise exempt from income taxes through various exemptions and...
and 1976
Tax Reform Act of 1976
The Tax Reform Act of 1976 was passed by the United States Congress in September of 1976, and signed into law by President Gerald Ford on October 4, 1976, becoming ....
Tax Reform Acts. In 1978, Congress reduced capital gains tax rates by eliminating the minimum tax on excluded gains and increasing the exclusion to 60 percent, thereby reducing the maximum rate to 28 percent. The 1981 tax rate reductions further reduced capital gains rates to a maximum of 20 percent.
The Tax Reform Act of 1986
Tax Reform Act of 1986
The U.S. Congress passed the Tax Reform Act of 1986 to simplify the income tax code, broaden the tax base and eliminate many tax shelters and other preferences...
repealed the exclusion of long-term gains, raising the maximum rate to 28 percent (33 percent for taxpayers subject to phaseouts). When the top ordinary tax rates were increased by the 1990 and 1993 budget acts, an alternative tax rate of 28 percent was provided. Effective tax rates exceeded 28 percent for many high-income taxpayers, however, because of interactions with other tax provisions. The new lower rates for 18-month and five-year assets were adopted in 1997 with the Taxpayer Relief Act of 1997
Taxpayer Relief Act of 1997
The Taxpayer Relief Act of 1997 reduced several federal taxes in the United States.Subject to certain phase-in rules, the top capital gains rate fell from 28% to 20%. The 15% bracket was lowered to 10%....
. In 2001, President George W. Bush
George W. Bush
George Walker Bush is an American politician who served as the 43rd President of the United States, from 2001 to 2009. Before that, he was the 46th Governor of Texas, having served from 1995 to 2000....
signed the Economic Growth and Tax Relief Reconciliation Act of 2001
Economic Growth and Tax Relief Reconciliation Act of 2001
The Economic Growth and Tax Relief Reconciliation Act of 2001 , was a sweeping piece of tax legislation in the United States by President George W. Bush...
, into law as part of a $1.35 trillion tax cut program.
Tax rates for 2009
- Note: the dollar amount refers to taxable income, not adjusted gross income (AGI).
Marginal Ordinary Income Tax Rate Single Married Filing Jointly or Qualified Widow(er) Married Filing Separately Head of Household 10% $0–$8,350 $0–$16,700 $0–$8,350 $0–$11,950 15% $8,351– $33,950 $16,701–$67,900 $8,351–$33,950 $11,951–$45,500 25% $33,951–$82,250 $67,901–$137,050 $33,951–$68,525 $45,501–$117,450 28% $82,251–$171,550 $137,051–$208,850 $68,525–$104,425 $117,451–$190,200 33% $171,551–$372,950 $208,851–$372,950 $104,426–$186,475 $190,201–$372,950 35% $372,951+ $372,951+ $186,476+ $372,951+
Short-term capital gains are taxed as ordinary income rates as listed above. Long-term capital gains have lower rates corresponding to an individual’s marginal ordinary income tax rate, with special rates for a variety of capital goods.
| Ordinary income rate | Long-term capital gain rate | Short-term capital gain rate | Long-term gain on real estate* | Long-term gain on collectibles | Long-term gain on certain small business stock |
|---|---|---|---|---|---|
| 10% | 0% | 10% | 10% | 10% | 10% |
| 15% | 0% | 15% | 15% | 15% | 15% |
| 25% | 15% | 25% | 25% | 25% | 25% |
| 28% | 15% | 28% | 25% | 28% | 28% |
| 33% | 15% | 33% | 25% | 28% | 28% |
| 35% | 15% | 35% | 25% | 28% | 28% |
Small company stock capital gains
Section 2011 of the Small Business Jobs Act of 2010Small Business Jobs Act of 2010
The Small Business Jobs Act of 2010 is a federal law passed by the 111th United States Congress and signed into law by President Barack Obama on September 27, 2010...
exempts 100% of the taxes on capital gains for angel and venture capital investors on small business investments if held for 5 years. However, this exemption only applies to shares of stock. It excludes convertible debt and warrants which are major components of most angel and venture capital arrangements. This is a temporary measure that applies to stock bought after September 27, 2010 but before January 1, 2011.
The temporary 100% exclusion of capital gain from the sale of certain small business stock under IRC § 1202 was extended further through 2011 by the H.R. 4853: Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010
Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010
The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 , was passed by the United States Congress on December 16, 2010 and signed into law by President Barack Obama on December 17, 2010....
as a jobs stimulus http://www.journalofaccountancy.com/Web/20103682.htm http://www.jdsupra.com/post/documentViewer.aspx?fid=7aa573b0-641c-4f87-a5b3-e8aceb48aab9.
In addition, a problem with alternative minimum tax
Alternative Minimum Tax
The Alternative Minimum Tax is an income tax imposed by the United States federal government on individuals, corporations, estates, and trusts. AMT is imposed at a nearly flat rate on an adjusted amount of taxable income above a certain threshold . This exemption is substantially higher than the...
associated with the sale of company stock was fixed http://www.schwabe.com/showarticle.aspx?Show=12138.
The President’s new budget in year 2011 will propose making permanent the elimination of capital gains taxes on key investments in small businesses, which was passed as a temporary provision in 2010 as part of the Small Business Jobs Act of 2010
Small Business Jobs Act of 2010
The Small Business Jobs Act of 2010 is a federal law passed by the 111th United States Congress and signed into law by President Barack Obama on September 27, 2010...
the President signed in September. The budget will also propose expanding the New Markets Tax Credit Program
New Markets Tax Credit Program
The New Markets Tax Credit Program was established in 2000 as part of the Community Renewal Tax Relief Act 2000. The goal of the program is to spur revitalization efforts of low-income and impoverished communities across the United States and Territories...
to encourage private sector investment in startups and small businesses operating in lower-income communities. http://www.whitehouse.gov/the-press-office/2011/01/31/white-house-launch-startup-america-initiative
Primary residence
Under 26 U.S.C. §121 an individual can exclude up to $250,000 ($500,000 for a married couple filing jointly) of capital gains on the sale of real property if the owner used it as primary residence for two of the five years before the date of sale. The two years of residency do not have to be continuous. An individual may meet the ownership and use tests during different 2-year periods. Both tests must be satisfied during the 5-year period ending on the date of the sale. There are allowances and exceptions for military service, disability, partial residence and other reasons. The $250K ($500K married filing jointly) exemption is not increased for home ownership beyond 5 years. The $250,000 ($500,000 for a married couple filing jointly) is not available to properties bought by 1031 exchange. Capital gains on rental property can be totally avoided by using 1031 exchange. One strategy that is sometimes employed is for a homeowner to move out of the primary residence, rent it out for a period of time, evict the renters, exchange for a new house, rent the new house out, evict the new renters, and then move into the new house, thereby avoiding capital gains tax.1031 exchange can also be used to avoid capital gains by renting out part of your principal residence.Section 121 provides no benefit if there is a loss on the sale of the property. One is not able to deduct a loss on the sale of one's home.
According to real estate lawyer Robert Bruss, a long commute does not allow a partial exemption in tax to move closer to work. In an article in the Washington Post, Bruss pointed out that bankruptcy of your present employer would likely permit a homeowner a partial use of the $250K / $500K exemption to allow a homeowner to move to a new job in a different city. According to an article in the Washington Post, a taxpayer can move more often to avoid capital gains tax in expensive areas.
Capital losses
If an individual or corporation realizes both capital gains and capital losses in the same year, the losses (except losses from the sale of personal property including a residence) cancel out the gains in the calculation of taxable gains. For this reason, toward the end of each calendar year, there is a tendency for many investors to sell their investments that have lost value. For individuals, if losses exceed gains in a year, the losses can be claimed as a tax deductionTax deduction
Income tax systems generally allow a tax deduction, i.e., a reduction of the income subject to tax, for various items, especially expenses incurred to produce income. Often these deductions are subject to limitations or conditions...
against ordinary income, up to $3,000 per year ($1,500 in the case of a married individual filing separately). Any additional net capital loss of the individual can be "carried over" into the next year and "netted out" against gains for that year. Corporations are permitted to carry capital losses back three years to off-set capital gains from prior years, thus earning a kind of retroactive refund of capital gains taxes. After the carryback, a corporation may carry the unused portion of the loss forward five years.
Deferment strategies
Capital gains tax can be deferred or reduced if a seller utilizes the proper sales method and/or deferral technique. The IRS allows for individuals to defer capital gains taxes with tax planning strategies such as the structured saleStructured sale
A structured sale is a special type of installment sale pursuant to the Internal Revenue Code. Installment sales permit sellers to defer recognition of gains on the sale of a business or real estate to the tax year in which the related sale proceeds are received...
(ensured installment sale), charitable trust
Charitable trust
A charitable trust is an irrevocable trust established for charitable purposes, and is a more specific term than "charitable organization".-United States:...
(CRT), installment sale, private annuity trust
Private annuity trust
A private annuity trust enables the value of highly appreciated assets, such as real estate, collectables or an investment portfolio, to be realized without directly selling them and incurring substantial taxes from their sale....
(no longer valid), and a 1031 exchange.
- Deferred sales trust – Allows the seller of property to defer capital gains tax due at the time of sale over a period of time.
- 1031 exchange – Defer tax by exchanging for "like kind" property. Capital gains can be deferred forever by buying a replacement real estate by a business, but not for personal real estate.
- Structured saleStructured saleA structured sale is a special type of installment sale pursuant to the Internal Revenue Code. Installment sales permit sellers to defer recognition of gains on the sale of a business or real estate to the tax year in which the related sale proceeds are received...
annuity (aka Ensured Installment Sale) – Defer and reduce capital gains tax while gaining safety and a stream of guaranteed income. - Charitable trustCharitable trustA charitable trust is an irrevocable trust established for charitable purposes, and is a more specific term than "charitable organization".-United States:...
– Defer and reduce capital gains by giving equity to a charity. - Self directed installment sale (SDIS) – Allows for the deferral of capital gains taxes while removing the risks from buyer default under a traditional installment sale.
No offset for gains due to inflation
The capital gain upon which the tax is calculated is not inflation adjusted. Thus, a gain that is entirely due to inflation is not a real gain at all, nevertheless this illusory gainMoney illusion
In economics, money illusion refers to the tendency of people to think of currency in nominal, rather than real, terms. In other words, the numerical/face value of money is mistaken for its purchasing power...
is taxed. Similarly, gains that do not even keep pace with inflation are still treated as gains when they are in fact losses http://online.wsj.com/article/SB115983941679680708.html.