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Capital Gains Tax – The Basics

The Basics of Capital Gains TaxRecently, I was asked about the capital gains rate and how it’s going to change on January 1, 2013.

It’s easy to get confused when the tax laws change every year.  Never mind that it’s an election year to boot!

This article will help you understand the basics of the capital gains tax and how it’s slated to change as part of the expiring “Bush tax cuts” on January 1, 2013 (info current as of October 24, 2012).

Capital Gains 101

In general, the “capital gains tax” applies when you sell any property that you own, including stocks, bonds, your home, land, household furniture, and other assets.  The difference between what you paid (your “cost basis”) and the sales price (“proceeds”) is your capital gain or loss.

Some definitions:

  • “Long-term” refers to property you’ve owned for more than one year
  • “Short-term” refers to property you’ve owned for less than one year

Things to be aware of:

  • There’s an exclusion from capital gains tax on the sale of your primary residence, which is $250,000 for single taxpayers and $500,000 for married couples
  • You can only deduct $3,000 of net capital losses each year on your Form 1040 tax return ($1,500 if married filing separately)
  • Excess capital losses carry forward and can be deducted against future capital gains
  • Short-term capital gains are taxed at your ordinary income rate (currently ranging from 10% to 35%)
  • In addition to federal capital gains tax rates, you may also be subject to additional state capital gains tax rates
  • Many states do not have a separate capital gains rate, and tax your long and short-term capital gains as ordinary income

Special items to be aware of:

  • “Collectibles” (e.g. art, rugs, antiques, metal or gems, stamps, coins, alcoholic beverages) are subject to a higher long-term capital gains rate (currently 28%)
  • Real estate that has been depreciated is subject to a 25% depreciation “recapture”

The Current Situation

Currently, long-term capital gain income is taxed at a lower rate than short-term gains and ordinary (e.g. wage) income.

These special rates are:

  • ZERO percent if you are in the 10% or 15% income brackets (after including capital gains)
  • FIFTEEN percent if you are in the 25% income bracket or higher

How They’re Going to Change

Barring any post-election or early 2013 tax deals, here’s how the long-term capital gains rates are going to change:

  • TEN percent if you are in the 15% bracket (note that the 10% income tax bracket is also scheduled to expire)
  • TWENTY percent if you are in a higher income tax bracket

The New 3.8% Medicare Surtax

Effective January 1, 2013 there will be an additional 3.8% tax on all “unearned income” that exceeds certain thresholds.  It’s called the “Unearned Income Medicare Contribution Tax” a.k.a the “Medicare Surtax”.

For the purposes of this surtax, unearned income includes:

  • Interest (except municipal bonds)
  • Dividends
  • Capital gains
  • Rents and royalties
  • Pass-through income from a passive businesses (e.g. partnerships, LLCs, or S corps)

In general, this surtax will only apply to higher income individuals, and it will apply to the lower of your net investment income for the year or your “modified” adjusted gross income that exceeds a certain threshold.

Not surprisingly, the actual calculations will be a bit tricky (for example – you must first calculate your “modified” adjusted gross income) and can depend on several factors (there are exceptions for certain items), but in general the surtax will apply to:

  • Single individuals with a modified adjusted gross income of $200,000 or more
  • Married taxpayers with a modified adjusted gross income of $250,000 or more
  • Married taxpayers filing separately with a modified adjusted gross income of $125,000 or more
  • Trusts or estates that file their own returns and have modified adjusted gross income of $11,650 or more

Further Reading

If you’re interested in learning more about this topic, here’s a few interesting articles to get you started:

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