The Internal Revenue Service treats every asset you own as a capital asset that is subject to the capital gains tax laws when you sell it and earn a profit. Common types of capital assets include your home, cars, stock portfolio and household items. When you sell one of these assets, you also need to consider your holding period, because the IRS imposes different rates of tax on your short-term capital gains than it does on your long-term gains.
Capital Gains Fundamentals
At the time you purchase or construct a capital asset, there are no tax implications that you must deal with yet. However, you do need to keep track of your tax basis in the asset. You can think of an asset's tax basis as your total cost or investment in it. Tax basis is an essential component of the capital asset tax laws because only the sale proceeds you receive in excess of basis are subject to the capital gains tax. To illustrate, suppose you purchase a rare baseball card collection for $100 in 2002 and in 2004 purchase additional cards for $50. If you sell the entire collection in 2011 for $1,000, you subtract your $150 tax basis from the sale proceeds to arrive at a capital gain of $850.
Short or Long
After calculating your capital gains, you must determine the holding period of each asset so that you can separate your long-term and short-term gains. Your short-term capital gains include all assets that you own for one year or less before the sale. Logically, your long-term gains include the assets you own for more than one year. Classifying each transaction appropriately is important because only your long-term capital gains are subject to the capital gains tax rates, which are lower than the ordinary income tax rates the IRS imposes on your short-term capital gains.
How to Report
The IRS wants to know all the details of your capital asset transactions, regardless of whether it results in a gain or loss. For this reason, the agency requires you to prepare a Schedule D attachment to your return. The Schedule D reports the tax basis, sales price, holding period and transaction dates for each asset. This allows you to separately calculate the net gain or loss for your short-term and long-term transactions. Ultimately, however, you net the two results together to arrive at your overall capital gain or loss.
Reducing Capital Gains
You can always reduce your capital gains with capital losses, even if it eliminates the taxable gain entirely. However, if you incur net capital losses in prior years, you can carry them forward to eliminate the capital gains you generate in the current and future tax years. You should also be aware that the tax law allows you to exclude up to $250,000 ($500,000 if filing jointly) of the capital gain that results from the sale of your main home, provided you reside there and own it for two years during the five-year period that ends on the date of sale.
- Adrian Samson/Lifesize/Getty Images