As a business’s assets rise or fall in value, the result is either a capital gain (an increase in value) or capital loss (a decrease in value). The vast majority of assets are considered capital assets, but not all. Further, capital gains and losses are each heavily regulated by tax codes and require additional attention during tax preparation.
There are multiple layers of complexity involved, which is why we’ve put together this guide to address the subject. Of course, we recommend speaking to your tax expert if capital gains taxes are applicable to your situation.
What’s Considered a Capital Asset?
Capital gains and losses are only applicable to capital assets. What’s a capital asset? Generally, capital assets are those used to earn revenue, and they’re typically held in ownership for more than a single accounting period.
That’s a wide definition, and one that can include both physical and conceptual assets. Some examples include:
- Real estate properties and buildings
- Hardware, equipment, and machinery used for business operations
- Vehicles used for business operations
- Intellectual properties, including copyrights and patents
- Various investments, including securities and bonds
A lot falls under the capital asset umbrella. Here is what is not included:
- Bank accounts and cash held by the business
- Any materials or supplies used to manufacture goods
- Inventory held short-term for sale
- Any accounts receivable
- Insurance premiums and any property being rented
The tax implications of a capital gain or loss are typically triggered until a capital asset is sold. If the asset is sold at a higher price than it was purchased at, capital gains taxes will apply. If the asset is sold at a loss, then capital loss deductions may apply.
What’s the Difference Between a Short-Term and Long-Term Capital Asset?
In addition to the above, there are short-term and long-term capital assets. This categorization is extremely important, as short-term and long-term capital assets are taxed differently.
A short-term capital asset is one held for a year or less before it’s sold. A long-term capital asset is held for at least a year prior to disposal. For tax purposes, the holding period starts the day the asset is purchased, and ends the day the asset is sold.
Short-term capital assets are typically acquired with the intent of selling them off right away. This includes stocks, bonds, securities, and real estate. Long-term capital assets may also include real estate (such as a homeowner selling their house prior to moving), stocks, and securities. Mutual funds are a common example of longer-term security investments.
There are few exceptions to these holding rules. One, though, is how inherited property is categorized. Inherited property is always considered a long-term asset, no matter how long the beneficiary has held it.
How Are Capital Gains Calculated for Mutual Funds?
Mutual funds combine an array of assets into a single portfolio and are overseen by professional fund managers. When investors buy into a mutual fund, they’re buying a portion of that portfolio’s assets.
When an investor sells part of their mutual fund portfolio, the resulting gain is taxed. It can be a challenge, though, to determine exactly what the gain is, and how its holding period should be determined. This is because investors may buy into (or sell out of) a mutual fund several times over many years.
To determine gain or loss, there are two methods available to mutual fund investors. They include:
- Cost basis – There are two ways to use a cost basis to calculate gain or loss. One way is to specify which shares are to be sold when it’s time to sell. The value and holding period of these shares is used to determine gain or loss.
The other way is the First-in, First-out (FIFO) method. With FIFO, the longest-held shares are assumed to be sold first. The value and holding period are used in the gain or loss calculation.
- Average basis – If a cost basis has not been previously used to calculate a mutual fund’s holding period, an average basis can be used instead. When using an average basis to calculate gains or losses, the total value of the investor’s holdings is compared to the number of shares owned. When shares are sold, the resulting gain or loss is calculated by taking the average and multiplying it by the number of shares.
How Are Capital Gains and Losses Taxed?
Capital gains are taxed according to how long they’ve been held. The holding period, again, is defined by the day of purchase and the day of asset disposal (selling). Here’s a quick look at how short and long-term gains are taxed:
- Short-term capital gains – Short-term capital gains are taxed at the holder’s highest income tax bracket. For example, if a single tax filer is preparing their 2023 taxes and reports $100,000 in income and an additional $20,000 in short-term capital gains, those gains are taxed at 24 percent – the 24 percent tax bracket starts at $95,375 for 2023.
- Long-term capital gains – Long-term capital gains are treated more favorably for tax purposes. These are taxed using a different set of tax brackets, with rates ranging from 0 to 20 percent. Specifically, long-term capital gains aren’t taxed until they total at least $41,675. Between $41,676 and $459,750, the long-term capital asset tax rate is 15 percent. Long-term capital gains in excess of $459,750 are taxed at 20 percent.
Capital losses are also a tax factor. If assets depreciate in value during holding and are sold at a loss, the resulting loss is deducted from income for tax purposes. There is a capital loss dedication limit at $3,000 per year, but capital losses can be carried over into future years, when they can be deducted from future income.
Capital Gains and Losses Can Have a Major Impact on Your Taxes, so Consulting with an Expert is Recommended
Taxes get complicated quickly when capital gains and losses are involved. What constitutes a capital asset, determining holding periods, and ensuring all assets are accounted for – these are all challenges that taxpayers face come tax season. Further, capital assets can also create multi-year tax ramifications that must be considered in advance to fully optimize.
Resolving the above is what tax preparation and planning experts provide to their clients. If you’re expecting capital gains and losses to factor into your tax preparation this season, speak with a tax expert to determine the best course of action.
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