You might be among those who find the federal tax code difficult to understand since it involves so many rules, exceptions to those rules and continuing changes. However, you might be especially confused by the parts of the code which apply to “capital gains and losses,” which for decades have been treated differently than ordinary income by the Internal Revenue Service (IRS). This issue is of critical importance because building wealth, including for retirement, often is through the acquisition and sale of assets, not by working at jobs or running a business. Here is an explanation about the fundamentals of capital gains taxation policies.
When it comes to taxing assets of individuals like yourself, the IRS looks at:
- Personal property: Such as a piece of art or the house you live in.
- Investment property: Such as the rental you own.
- Retirement accounts: Such as 401Ks.
- Securities: Such as individual stocks, mutual funds and ETFs (Exchange Traded Funds).
You might have purchased those assets or inherited them from someone who had died and they get on the radar screen of the IRS when a gain or loss is realized. Some assume that happens when the asset is sold, such as when someone cashes out a security. However, with the introduction of new kinds of investment vehicles, there could be capital gains distributed, as with the ETF, even if the security is not sold that year. A 2012 survey done on behalf of investment firm BlackRock found that 55 percent of those interviewed didn’t know this. That’s exactly why taxpayers must keep up-to-date with the details of federal capital gains tax policies on all their assets or have their filing prepared by a professional tax expert.
History Of Income Tax Policies
In 1862, Congress passed the first progressive or graduated income tax law which laid the foundation for the current system. That was declared unconstitutional in 1895 and it wasn’t until the 16th Amendment to the Constitution in 1913 that this kind of income tax for ordinary income and gains from assets became a permanent responsibility in American life. From the get-go, there was debate about how to tax the gain from the sale of property. As you might remember from American history class, private property was an especially valued entity in this nation, dating back to colonial times and extending to the present wealthy real estate developers. In 1922, this ambiguity was resolved and capital gains were to be taxed at a lower rate than ordinary income. Throughout most of the history of taxation in the U.S., capital gains have received that preferential treatment.
Forms Of Preferential Treatment
The forms that preferential treatment has taken have varied greatly over the years. For example, from 1934 through 1941, taxpayers were able to shield a percentage of the gains from any taxes based on how long they held the asset. That concept of a specified holding period has been maintained through the differentiation between long-term and short-term assets. Those owned for more than a year have been allowed preferential treatment while those held 365 days or less frequently have been taxed as ordinary income. As long as this remains in effect, you must pay attention to how long you hold an asset.
In 2001, the Economic Growth and Tax Relief Act, signed by President George W. Bush, significantly lowered capital gains rates but tied them to the individual’s ordinary income tax rate, along with special rates for specific kinds of assets. In 2013, the Act’s will have expired. Given the history of the U.S. tax code, there will likely be myriad ongoing changes in capital gains policies for as long as the nation exists.
Another important kind of preferential treatment is the forgiveness of capital gains taxes when someone dies, known as the step-up in basis rule. Those inheriting the assets don’t pay tax on assets until they’re sold and then only on the gain calculated from the time of inheritance to the time of sale.
A third type of preferential treatment was the result of the Small Business Jobs Act of 2010 which forgives 100 percent of taxes on capital gains for angel and venture capital investors when the security is held for five years.
Over time, some provisions have become more or less standard. They include:
- No tax on profits from the sale of the personal residence for up to $250,000 for an individual and $500,000 for a married couple. The holding period is two years.
- No recognition of loss on private property, just investment property.
- No tax on gains in retirement funds when not withdrawn until age 59 1/2 and then at that age gains are taxed as ordinary income. The rationale is that by age 59 1/2 individuals will be in a lower tax bracket.
- No tax on gains in stocks and mutual funds until sold.
- Losses from retirement funds, stocks and mutual funds can be deducted from ordinary income up to a certain limit, making the overall tax liability less. When losses exceed the limit, another deduction can be taken the next year.
However, like all provisions in the tax code, these could change.
IRS Revenues From Capital Gains
The U.S. government receives only a small portion of its tax revenue from capital gains. According to a 2010 report from the Congressional Budget Office, those revenues generated an average of 9.2 percent of individual tax revenue during the fiscal years 1995 to 2009. However, there were major fluctuations in the specific percentage for a specific year, that being 6.3 percent in 2003 and 11.8 percent in 2000.
Theories About Role Of Capital Gains Taxation
The subject of the rate of taxation for capital gains has been controversial and not only because of the money involved. In addition, economists have held conflicting theories about the role policies play in GDP growth and individual building of wealth. Among the theories are:
- Reductions provide/do not provide an economic stimulus. People have incentive/no incentive to invest in enterprises as well as securities. That can/cannot create new jobs.
- Reductions have small/large impact on savings level.
- Reductions primarily benefit the wealthy, not the middle class.
It’s up to you to determine which arguments seem to make financial common sense and are backed by evidence that seems credible.
Anyone who has property, a retirement account and investments or expects to inherit assets has to be concerned about tax policies related to capital gains and losses. Your financial security and opportunity to build, protect and grow wealth depend on it.