The average American taxpayer lets the chips fall where they may when it comes to reporting capital gains and losses on their tax returns. So that we all understand, let's review the rules for capital gain and loss netting. Capital gains and losses are divided into two types; long-term and short-term. A long-term transaction is one that involves the holding of a given asset for more than one year. Conversely, a short-term transaction involves the holding a given asset for less than one year. The importance of the holding periods relates to the rate of income tax to be paid on the transaction. Under current law, long-term capital gains are taxed at a maximum rate of 15%. Short-term gains are taxed at the maximum incremental rate of the taxpayer. This rate could be as high as 35%. Long-term capital gains and losses net against each other as do short-term capital gains and losses. To the extent that losses exceed gains, the capital losses will offset other forms of income up to $3,000 with the balance being carried forward indefinitely. The capital loss carry forward will maintain its respective classification as either long-term or short-term.
The tax planning opportunities for recognizing capital gains and losses are a plenty believe it or not. First of all, it is important to point out that the amount of the gain or loss to be recognized can be controlled. There are two ways to recognize capital transactions. The first in first out method (FIFO) assumes that the first or oldest asset acquisition is being sold. The FIFO method is the default method for recognizing gains and losses if the specific identification method is not used. The specific identification method allows the taxpayer to identify which asset (or block of shares) is being sold. For example, the taxpayer owns two blocks of IBM shares as follows:
September 1, 1990 1,000 shares at $30 $30,000
September 1, 2004 1,000 shares at $50 $50,000
On November 1, 2006, the taxpayer wants money to pay bills and pay college tuition. On this day, the price of IBM shares is $45 per share. Let's assume that the taxpayer does not have any capital loss carry forwards. To avoid paying long-term capital gains tax of $2,250 (15%x$15,000), the taxpayer notifies his broker in writing that he wishes to sell the September 2004 block of shares. This would create a long-term capital loss of $5,000 ($45,000 selling price less $50,000 acquisition cost). If there are no other capital transactions for the year, the taxpayer will get a $3,000 capital loss deduction against other income. Assume a 35% tax rate and this taxpayer gets a $1,050 tax savings in 2006. By knowing the specific identification rules exist, the swing in tax savings is $3,300 ($1,050+$2,250). The remaining balance of capital loss is $2,000 ($5,000 less $3,000 recognized) and is carried forward as a long-term capital loss indefinitely.
Another key tax planning tactic involves the timing in netting capital gains and losses. Let's assume that a taxpayer has the following transactions during the year:
Long-term capital loss carry forward of $20,000
Short-term capital gain on stock transactions, $20,000
Long-term capital gain on sale of land, $20,000
Taxpayer is in the top tax bracket of 35%
In this example, the long-term capital gain must first be netted with the long-term capital loss. This will eliminate the 15% tax on the long-term capital gain of $20,000. The tax due on capital transactions in the current year will be $7,000 ($20,000 x 35%). What could this taxpayer have done differently? Suppose he could have gotten a contract to sell the land in the next year. This would then allow the short-term capital gain to be reduced by the long-term capital loss. Remember that capital gains and losses must first be netted within their respective classes. After this ordering, any leftover long-term or short-term loss can be netted against the other category's gain. If the taxpayer holds off the land sale until next year, the short-term capital gain goes to zero in the current year. In the year to follow, the taxpayer will pay $3,000 in long-term capital gains tax (15% x $20,000). This not only saves the taxpayer $4,000 in tax on capital transactions ($7,000-$3,000), but postpones the payment of tax for one year.
In summary, understanding how capital transactions work can provide taxpayers with the potential to save a significant amount of income tax. Don't just let the chips fall where they may, take a look at what you have and keep records. This is a classic example of knowledge is power.
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