Capital Gains/Losses

Capital gains are a common way to grow your wealth, especially when you’re investing in securities or real estate. Securities encompass a variety of investments like stocks, mutual funds, ETFs, and bonds. Now, if the value of an asset goes up (price appreciation) and you decide to sell, that increase in value is what we call a capital gain. If the price falls, you get a capital loss. We shall refer to both as capital gains, where losses are negative values. However, the interests from bonds, dividends from stocks are not a capital gain.

Capital gains are classified into two categories based on how long you’ve held the asset before selling it. If you’ve held the asset for more than a year, the gain is considered a long-term capital gain (LTCG); if the holding period is shorter, it’s classified as short term. The IRS sets out the full rules in IRS Topic 409. By aligning your investment horizon with the long-term capital gains tax incentives, you can significantly reduce your tax liability, thereby increasing your net worth over time. This doesn’t necessarily mean you should never engage in short-term trading—if done wisely and selectively, it can be a valuable part of your overall investment strategy.

The Preferential Treatment of LTCG exists on purpose: Congress wants patient capital, and part of any multi-year nominal gain is simple inflation, not real economic return. The lower rate is the incentive and a rough inflation adjustment rolled into one.

Strategic Considerations You experience capital gains when you sell your assets for more than you bought it. The important thing to note is that capital gains taxes only come into play at the time of sale. This means if you’re holding onto assets that have increased in value, like your securities or real estate, the embedded tax bill is part of the cost of selling, and it belongs in the hold-or-sell comparison alongside the expected return of whatever you would buy instead.

In particular,

• You may try to wait for a year when your tax brackets are lower to sell.
• If securities are gifted, the recipient inherits the basis, and they will have to pay capital gains taxes when they sell. There are no immediate tax consequences to you or the recipient.
• If securities are directly given to a charity or a 501(c)(3), the charity sells the security, but as a non-profit they do not pay capital gains taxes. Because the charity sold the security instead of you, you do not incur capital gains. And the charity gets the full market value of your donation.

Capital gains and losses negate each other. You cannot have both a net capital gain and net a capital loss in a single year in your tax return. The negation occurs as follows:

1.

Short term gains negate short term losses. (Rule 1)

2.

Long term gains negate long term losses. (Rule 2)

3.

If you have a gain and a loss from the previous negations, negate the short term and long term, giving a single gain or loss, categorized based on the bigger value or “winner”. (Rule 3)

4.

If you had purely gains or purely losses for both short term and long term, keep both values categorized separately. (Rule 4)

5.

Long term gains are taxed at LTCG rates. Short term gains are taxed as ordinary income. (Rule 5)

6.

Up to $3K of capital losses of any kind offsets ordinary income. (Rule 6)

7.

The excess loss beyond $3K is carried over to the next year. (Rule 7). In the next year(s), carry over loss is no different than “regular” capital losses and is used in the negation process normally. The losses retain their characterization as short-term or long-term when carried over.

8.

If you have both short term and long term losses, the short term losses are used first to offset ordinary income. (Rule 8)

Let’s demonstrate this with a few examples:

In Table 6.4 the short-term gain negates some long-term loss, leaving a final long term loss of -$500. This loss is under $3K and is fully used to offset ordinary income.

In Table 6.5 there were both short-term and long-term losses. We used 3K first from short-term, then long-term to offset ordinary income.

In Table 6.6 the short-term gain negates the entire long-term loss, leaving a $4,200 net short-term gain that is taxed as ordinary income. There is no remaining loss to offset other income.