Tax Treatment for Capital Gains & Capital Losses

by Erika Johansen

Capital gains and losses refer to the profits and losses realized on the sale or transfer of certain types of assets. Tax law generally aggregates these capital gains and losses to determine whether a taxpayer may receive a more favorable tax rate. Those with specific questions about capital gains and losses should consult a tax professional.

Defining Capital Assets

Assets are the holdings of a taxpayer, which may come in many different forms. Capital assets are distinguished from normal assets based on the reason that the owner is holding the asset. A capital asset is an investment asset, one acquired with the primary (though not necessarily exclusive) intent of financial gain, through appreciation or other forms of growth. Internal Revenue Code Section 1221 attempts to define a capital asset and also lists numerous examples. Such appreciating assets may include securities, real property or collector's items. Assets that depreciate typically will not be considered capital assets, nor will assets that the taxpayer uses in a personal way, such as a primary residence.

Gains and Losses

In calculating whether a capital asset has taken a gain or a loss, the law looks at the appreciation or depreciation of the asset. This is calculated by comparing the value of the asset at the time of sale or transfer with the original cost of acquiring the asset (known as the asset's "basis"). This basis includes all costs associated with the original acquisition. If the basis is greater than the transfer value, the taxpayer has sustained a capital loss. If the transfer value is greater than the basis, the taxpayer has sustained a capital gain.

Long-Term Status

Ordinary capital gains and losses receive different treatment from so-called "long-term" capital gains and losses. A capital gain or loss becomes long-term once the the taxpayer has held the ownership of the capital asset (as opposed to actual physical possession) longer than one year.

Net Effects

Long-term capital losses have the ability to be "carried over" from one tax year to the next. If the entirety of one tax year's long-term capital gains is greater than the entirety of both that year's short-term capital loss, and any carried over long-term capital loss from a prior year, this constitutes a net capital gain. Although tax rates do fluctuate, net capital gains have normally received more favorable tax rates than the aggregate of ordinary gains and losses. Internal Revenue Code Section 1222 describes the specific methods of aggregating capital gains and losses to determine the net.