What Is a Capital Gain and What Does It Mean For My Taxes?
The capital gains tax is perhaps one of the most contentious and debated portions of the US tax code. Under the Reagan administration, the Tax Reform Act of 1986 raised the maximum capital gains rate from 20% up to 28%.
With the capital gains tax, one is legally obligated to report all capital gains (and thus pay tax) while only being able to deduct a percentage of capital losses—hence, the system is skewed and appears to punish risk-taking because all rewards or profits are taxed while losses are merely absorbed. But, while it may appear that the capital gains tax is little more than a tax penalty that punishes productivity and the accumulation of wealth, much depends on how the capital gain or loss is reported.
A capital gain (or loss) can be reported as either long term or short term, depending on how long the asset was held prior to liquidation. If an asset is held for more than a year prior to selling it, then it is a long term capital gain or loss. For all assets acquired and liquidated within a year or less, the gain or loss will be considered short term. Essentially, this means that this is a “voluntary tax” giving the taxpayer the ability to choose when the best time is to liquidate a particular asset.
A taxpayer can hold on to a particular asset for twenty-five years and not owe taxes until it is sold. Known as the “lock-in effect”, the ability to defer tax liability until the asset is sold tends to create an illusion of profits while simultaneously blocking billions of dollars from being reinvested into the economy. While a near constant turnover of assets (such as with real estate or even equities) would create pricing volatility, holding onto assets and delaying tax liability prevents the utilization of capital while continually under-funding the tax system until the capital gain is finally realized. While the actual capital is still actively propelling the economy, the taxes do not enter into the system until the gain is realized.
In the United States alone, it is estimated that there is more than $7.5 trillion in unrealized capital gains. The capital asset may be an IRA so it is still helping to drive economic activity but applicable taxes on annual profits will only apply when the asset is sold and thus the tax system appears to have been “slighted” during the period between when an asset was purchased and when it is sold for capital gain. However, taxes are ultimately collected when the asset is realized so the “books do balance”. Even if the asset is not realized by the initial investor, surviving members of the estate would still be required to pay capital gains on investments; however, there remain some points of contention with respect to the capital gains tax, including:
- Capital gains taxes represent a small percentage of tax revenue but large potential source of capital investment.
- Capital gains are not indexed for inflation. A seller pays not only the true gain in purchasing power from the capital asset—but also any “illusionary” purchasing power brought on by inflation. So, if someone bought 100 shares of IBM stock in 1960 for $2 each and then sold them in 1995 for $180 each then the long term capital gain would be $17,800 ($180 - $2 times 100 shares) and you would be liable for up to 28% of that amount. However, in terms of real purchasing power, the true gain might be significantly less meaning that it was effectively over-taxed. This is why the tax rate on capital gains is typically lower than for other income types, but it cannot always compensate for the effect of inflation, especially over long periods of time.
- Must claim all capital gains but can only deduct up to $3,000 annual loss (up to $1500 if filing as single)
- Double taxation on capital formation. The capital gains tax is designed to tax both the value of the asset along with its yield. Take any potential profits from a stock sale: when purchased the value of that stock was based upon the discounted present value of all expected future earnings. Thus, if a particular company expected to have annual earnings of $1,000,000 per year over the next decade, that expectation would be built into the value of the stock. By taxing based upon the final value of the asset when sold versus original purchase price, the taxpayer is being forced to pay tax based upon both final value plus the yield—it’s double taxation because that yield should already have been factored into the final value of the stock!
Despite accounting for as little as 3% of total tax revenues, the capital gains tax continues to stir debate because of its connection with the “poor” vs. “rich” divide. Some argue that the tax discourages investment because it does not permit investors to fully deduct losses (only up to $1,500 if filing single) while all gains are taxed. Because it is possible to defer tax liabilities for several years, the effects of inflation may lead to “over-taxation” when the true purchasing power is taken into account. Despite these points of contention, however, the capital gains tax appears to be a permanent fixture in the tax code and is not likely to disappear any time soon.