When you buy property, you buy a "capital item." What you paid for the property is called your "basis." If you keep it for more than one year and then sell it for more than your basis, you will have a "long term capital gain." Long term capital gains are taxed at lower rates than is ordinary income. Sometimes you can even defer the gain altogether by a "tax free exchange."
If you sell your property for less than its basis, you would have a capital loss. Losses can be netted against capital gains to reduce the overall amount on which you have to pay taxes.
Two notes of caution.
First, for this discussion, the basis is assumed to be the price you pay for an item. In real life, the basis can be adjusted up or down through depreciation or improvements. Capital gains or losses are then figured as the difference between the sale price and the adjusted basis.
And second, if you sell your property after holding it less than a year, your gain (or loss) will be short-term rather than long-term. Short-term capital gains are taxed at the same rates as ordinary income. To get the long-term capital gain advantage, you must hold your property for at least a year and a day before selling it.
- What property qualifies for capital gains treatment?
- Short-term vs. long-term gains
- What is a "tax-free exchange"?
- Tax exempt bonds
- Mutual funds
- Do I need a tax professional?
What property qualifies for capital gains treatment?
Real property (including unimproved land) qualifies. Personal property (such as a car or a computer) qualifies. Intangible property such as stocks and bonds are also included. In fact, just about anything you can buy may qualify as a capital item.
Short-term vs. long-term gains
This can be illustrated by examples. If you buy ABC company stock on January 1, 2001, at $50 per share and sell it on February 1, 2002, at $60 per share, you will have a long-term capital gain of $10 per share. It would be taxed at the favorable long-term capital gain rates. If on the other hand you sold it at $55 per share on September 1, 2001, you would have a short-term capital gain of $5 per share. That gain would be taxed as ordinary income because you did not hold the asset for more than a year before selling it.
What is a "tax-free exchange"?
Many kinds of property used in a business or held for investment can be exchanged for "like kind" property without having to pay any tax. Instead of selling property and then buying new property, you trade the old property with someone for a new property. Special techniques have been developed to allow exchanges involving multiple parties and even delayed exchanges (in which the properties are not traded at the same time).
Traditionally, most tax-free exchanges have involved real property, but exchanges can be used for personal property as well. But there are specific types of property that will not qualify: stocks, bonds and other securities.
The detailed rules are quite technical and beyond the scope of this discussion, but if you qualify, this could be an excellent way to avoid taxes while getting rid of one property and acquiring another.
Tax exempt bonds
Some bonds (municipal bonds in particular) earn interest that is not taxed. The interest rate is usually lower than that for taxable bonds, but for taxpayers in the upper tax brackets, the after-tax interest rate can often be better.
Mutual funds
Many people now own shares of mutual funds, but very few consider the after-tax returns of those funds. When mutual funds sell stock they own, there are often capital gains. These gains are passed on to you at the end of each year as a long-term gain distribution (found on your 1099-DIV form). Actively managed funds buy and sell stock often during the year, creating more capital gains than funds that are not actively managed (such as index funds).
If you have both tax-deferred accounts (such as an IRA or 401k plan) and other accounts, you might consider holding actively managed funds in the tax-deferred accounts, because your gains will not be taxed until later when you withdraw money from the account. If you don't have such an account, then you should at least consider the tax bite of funds as part of your overall evaluation before you invest in them.
Do I need a tax professional?
For keeping good records, generally no help should be needed. On the other hand, for making a three-party tax-free delayed exchange, you will usually want some professional guidance.
In between those extremes, it depends. Many of the ideas presented in this discussion can best be carried out with some expert advice, because you must comply with technical requirements in order to qualify for tax benefits. Also, you should seek advice if your situation does not fit exactly into one of the categories discussed above.
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