Why should I be concerned about netting capital gains and losses?
This can be a complicated area of the law, but it offers some potentially lucrative tax savings if you pay attention to the rules that are available. If you have already had gains on capital items that you have sold during the year, you can match unrealized losses and sell them this year to lower or eliminate your tax on capital gains. And the opposite is true, if you have already realized losses you can sell capital gains items to effectively use up those losses. Otherwise, the losses are carried forward indefinitely until you have gains to match against the losses in the future. You will be able to deduct $3,000 of these losses each year to the extent that you do not have capital gains to match up against them, but that is it. With the time value of money, you lose ground each year you do not use these losses.
Capital Gains Rates
An advantage that capital assets have over other assets is that they are given a favorable tax rate when they are sold after holding them for at least a year. The current maximum long-term capital gains rate is at a historic low of 15 percent. This will not last forever. The current rate is scheduled to change in 2011 when it changes back to 20 percent. There are proposals to maintain the lower rate at certain levels of income, but these are just proposals now, and not law.
Capital Asset Holding Period is Critical
To take advantage of the lower capital gains tax rates you must hold the asset for the long-term, which is defined in the tax code as at least one year (defined as 12-months). Capital gains and losses are reported on Schedule D of your form 1040. Net Capital gains is the amount by which your net long-term capital gains exceed your net short-term capital loss. Qualified Dividends, although taxed at long term capital gains rates, are not included on Schedule D for netting purposes.
Netting of Capital Gains and Losses
Capital gains and losses must be netted. Total short-term capital gains and losses, and long-term gains and losses are first netted separately. The netting process applies to all capital assets and does not distinguish between different types of assets like stocks and bonds, real estate, etc.
In this process, short-term gains and losses, including any short term capital loss carryovers from prior years, are netted. If you have a net short-term capital loss, this can then be netted against any long-term capital gains you may have, or can create. However, if you have a net short-term capital gain this will be taxes at ordinary income tax rates since the required holding period of at least 12 months was not met. However, if you also net long-term capital losses you can offset these against your short-term capital gains.
Next Netting of Long-Term Capital Gains and Losses
Next, net your long-term capital gains and losses, including any long-term capital loss carryovers, and short-term capital losses. If you have a net Long-term capital loss it will be taxed at the favorable long-term capital gains tax rate. If you have a net long-term capital loss you can deduct up to $3000 of it in the current year. Any extra is carried forward indefinitely.
This area of the tax law is ripe with tax planning opportunities. You can use up carryovers from prior years, and losses in the current year to offset gains that you want to take in the current year. You can plan your sales so that they are long-term capital gains that allow you can take advantage of the lower long-term capital gains rate. The list goes on and can get quite creative.
Any individual seeking legal advice for their own situation should retain their own legal counsel as this response provides information that is general in nature and not specific to any person's unique situation. Circular 230 Disclaimer - Advice given in this response cannot be used to eliminate penalties with the IRS or any other governmental agency.
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