Capital gains & losses

Individuals or business that invest in capital assets receive two types of income: ordinary income and capital gains. Ordinary income includes dividends and interest you receive. You have a capital gain (loss) when you sell a capital asset for a profit (loss). Any asset you hold as an investment (stocks, bonds, real estate, for example) is a capital asset.

Advantages of capital gains

Capital gains are better than ordinary income for two reasons.

  1. There is no tax implication on capital gains until you sell the asset. Normally you can choose whether to sell sooner or later, so you control the timing of your gain or loss. For example, you can decide to sell late in December or early in January, depending on which year you want to report your gain or loss..
  2. Capital gains are taxed at special rates. Although, to qualify for these rates you must have long-term capital gains. A capital gain or loss is long-term if you held the asset more than one year (at least a year and a day) before you sold it. At that point you’re entitled to a special capital gain rate. the rate will be 15% (0%, as of 2008, if the gain falls in a tax bracket below 25%). There are exceptions for certain types of assets. A short-term capital gain is taxed at the same rates as ordinary income

Measuring capital gains (losses)

Your capital gain from a sale is measured by the difference between the amount realized in the sale and your basis in the asset you sold. Roughly speaking, the amount realized is what you received on the sale — usually the sale price minus the brokerage commission. Your basis is based on your cost , usually the purchase price plus the brokerage commission, but may be adjusted as a result of various events.

Example: You buy 100 shares of XYZ at $35, paying $3,500 plus a brokerage commission of $40. Your basis is $3,540. Later, you sell when the stock is at $39. You receive $3,900 minus a brokerage commission of $40, so your amount realized is $3,860. Your capital gain is $3,860 minus $3,540, or $320.

Capital losses are used first to offset capital gains. If there are no capital gains, or if the capital losses are larger than the capital gains, you can deduct the capital loss against your other income — up to a limit of $3,000 in one year. If your overall capital loss is more than $3,000, the excess carries over to the next year. In other words, you treat the extra portion as if it were an additional capital loss in the following year.

The wash sale rule

The tax law contains rules designed to prevent taxpayers from creating artificial capital losses. Under the wash sale rules you can’t claim a loss from sale of a security (such as stock) if you buy the identical security as a replacement within the period beginning 30 days before the sale and ending 30 days after the sale. So if you sell XYZ for a loss on December 30 and buy the same stock on January 5 of the next year, you won’t get a loss deduction for the sale on December 30. The wash sale rule only applies to losses. You can’t wipe out a gain from a sale by buying the same stock back within 30 days.

Consequences of a Wash Sale

The wash sale rule actually has three consequences:

  1. You are not allowed to claim the loss on your sale.
  2. Your disallowed loss is added to the basis of the replacement stock.
    • Example: Some time ago you bought 80 shares of XYZ at $50. The stock has declined to $30, and you sell it to take the loss deduction. But then you see some good news on XYZ and buy it back for $32, less than 31 days after the sale. You can’t deduct your loss of $20 per share. But you add $20 per share to the basis of your replacement shares. Those shares have a basis of $52 per share: the $32 you paid, plus the $20 wash sale adjustment. In most cases, this simply means you’ll get the same tax benefit at a later time.
  3. Your holding period for the replacement stock includes the holding period of the stock you sold: this rule prevents you from converting a long-term loss into a short-term loss.
    • Example: You’ve held shares of XYZ for years and it’s been a dog. You sell it at a loss but then buy it back within the wash sale period. When you sell the replacement stock, your gain or loss will be long-term — no matter how soon you sell it. In many situations you get more tax savings from a short-term loss than a long-term loss, so this rule generally works against you.
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