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Tax Basics
Explanation of the Capital Gains Tax and Related Issues
by InvestorGuide Staff (Write for us!)
(Click on a link within the article to get a definition of that word)
In relation to your home, you may be able to exclude the gains from the sell of your primary residence (the one you spend most of your time in) if you have lived in it for at least two consecutive years. The limit is $250,000 for singletaxpayers and $500,000 for married couples filing jointly.
The IRS divides capital gains into two distinct categories, with each having different tax consequences. Long-term capital
gains are gains on investments held for more than a year, while short-term capital gains are gains realized on investments that are held for a year or less. Short-term capital gains are taxed according to your incometax bracket and long-term gains are taxed at 20% if you are in the 28% or higher tax bracket, and only 10% if you are in the 15% bracket. In other words, long-term gains are subject to lower tax rates because the IRS wants to encourage long-term investing.
The Tax ReliefAct of 1997 created new rules, including low capital gains rates on assets held for more than five years:
If you are in the 15% income tax bracket you can take advantage of the five-year capital gains tax rates of 8%. This rate applies not only to investors who are single, but also to those married or filing jointly (granted you are still in the 15% tax bracket).
If you are in a higher tax bracket and your stocks and capital assets were acquired after December 31, 2000, you can take advantage of the five-year capital gains tax at a rate of 18%.
The cost basis of your investment, the amount that was originally paid for the investment, can be determined by several methods:
If you purchased the investment, the cost basis is the amount you paid for it.
If you inherited the investment, the cost basis is the value of the stock on the date of the original owner's death.
If
you received the investment as a gift, the cost basis is the amount that was originally paid for the investment, unless the market value of the investment on the date the gift was given was lower.
To determine the capital gains tax on an investment, subtract the amount paid for the investment, including any brokercommissions, from the sales price to arrive at the capital gain or loss. Then take this amount and multiply it by the appropriate tax rate, which will give you the tax owed on the sale of your investment.
In the case of a mutual fund investment, you will likely have a capital gains distribution, which is the profit that the mutual fund made by selling securities for more than their purchase price. Federallaw requires funds to distribute the realized capital gains and income to investors at least once a year. The tax status (short-term or long-term) of capital gains distributions is determined by the period of time that the mutual fund held the underlying security that was sold, not by how long you were invested in the fund.
One effective strategy for reducing capital gains taxes is to sell money-losing investments in the same year that you have offsetting capital gains, thereby reducing your capital gains taxes. In fact, if you still have a net loss position after offsetting all your gains with equivalent-sized losses, the IRS will allow you to apply as much as $3,000 pertax year toward a loss. If the losses are greater
than $3,000 you can carry those losses forward to later years indefinitely. For example, some investors try to sell their money-losing investments within the first year, so they can offset their highly-taxed short-term gains, while keeping their winners for more than a year whenever possible. There is one significant restriction on the use of this capital gains offset strategy. You cannot deduct losses from a security if you repurchase the same (or a substantially identical) security with 30 days before or after the sale. This is known as the "Wash Sale Rule", and it prevents investors from abusing the strategy by selling at a loss for tax purposes and then simply repurchasing. Wash Sale Rules are complex, and we encourage you to read the IRS guidelines about them.
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