Capital Gains Outline

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).

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