#12330 - Capital Gains - Taxation

Capital Gains

1. Special Rate for Capital Gains

1. History and Background. Throughout almost the entire history of the income tax, capital gains have been treated preferentially. The distinction between capital gain and ordinary income has been one of the major sources of income tax complexity. That is in part because “capital gain” is a creature of tax law, without a direct analogue in either economics or accounting.

2. Noncorporate Taxpayers. Currently, the holding period is 12 months to receive long-term capital gain treatment. Determining the tax on an individual’s capital gains involves a two-stage netting process. First, the taxpayer must separately net short-term gains and short-term losses. Then, the net short-term gain or loss is netted against the long-term gain or loss. If the taxpayer has both net STCG and net LTCG, each is taxed at its respective rate. However, if the taxpayer has a net short-term (long-term) loss, this can be used to offset long-term (short-term) gain. If both short-term and long-term capital losses exist, they are simply added together.

3. Capital Loss. Excess capital loss offsets up to $3,000 of ordinary income each taxable year. Any excess not allowed in one taxable year can be carried forward indefinitely until completely utilized. “Excess capital loss” is the lesser or $3,000 or the taxpayer’s “adjusted taxable income” (taxable income before the standard deduction and personal exemptions are taken).

4. Capital Gain on Small Business Stock. If a taxpayer holds stock from the date of issuance from a qualified small business (net worth less than $50 million) for at least five years, up to 50% of the gain is excludable. The remainder is taxed at a maximum 28% rate.

5. What is a Capital Asset? Capital assets include all property held by taxpayers that is not subject to an explicit statutory exception. Exceptions exist where property is “held primarily for sale to customers in the ordinary course of trade or business,” for “accounts or notes receivable acquired in the ordinary course of trade or business,” for “supplies regularly consumed by the taxpayer during the ordinary course of trade or business,” and for real or depreciable property, which is governed by §1231.

6. Held for Sale. Seven factors are considered in determining whether sales of land are considered sales of a capital asset or sales of property held primarily for sale to customers. See page 517. The Casebook suggests a rule of thumb in thinking about capital gains versus ordinary income is to ask where the seller’s profit comes from. If it is due to mark-up, repackaging, or something similar, it is ordinary income. If it is due to appreciation, it is capital gain. (See discussion on page 520).

7. Section 1231. Section 1231 allows certain real and depreciable property¹ used in a trade or business to yield capital gain when disposed of at a net gain and ordinary loss when disposed of at a net loss. Section 1231 requires a two-stage netting process. For purposes of determining whether net gain exists, a taxpayer takes into account net casualty income (if and only if there is positive income), and net income from sale or exchange of §1231 property. To ensure that the preferential treatment of §1231 applies only to net income, there is a recapture provision which requires a taxpayer to treat as ordinary income in any year the lesser of (1) the net §1231 gain for that year or (2) the net loss deducted under §1231 loss over the previous 5 years.

8. Section 1245. When a taxpayer sells 1245 property, she realizes ordinary income equal to the lesser of (1) the gain recognized on the sale of the asset or (2) prior depreciation taken on the asset. This prevents a taxpayer from being able to generate negative tax rates by investing in depreciable property (by purchasing depreciable property, taking depreciation deductions against ordinary income to reduce basis, and then selling the property at a price above his basis, generating income taxed at preferential capital gains rates) (see page 287 for an example).

Note that there are many circumstances...