As we get older, we generally acquire more and more assets. The assets usually start out small and become increasingly more valuable. Typically, as we become more independent and financially stable, we’ll buy our first car, start investing our money, and maybe even buy our first home.
The assets that we begin to acquire are referred to by the IRS as capital assets. Capital assets come with a complex tax code, but it’s important to decipher the basics because the tax laws on these assets will start to affect us as we grow older.
How capital assets work
When you own capital assets, they will not be affected by taxes or by the IRS. But, as soon as you start to sell or trade your assets, the IRS will catch on and start to care. When you sell your assets, you may be affected by capital gains and losses. It’s important to distinguish whether the gain or loss is long-term (more than one year) or short-term (less than one year), because both will come with different tax rates.
Capital gains are taxable similar to the way your income is taxed. However, long-term capital gains are taxed at much lower rates than your income. In fact, if you’re in the 10-15 percent income tax level, you won’t be taxed on long-term capital gains at all. Score!
On the other hand, when you take a loss, there is a possibility you could claim this loss on your taxes. And, of course, as with all tax laws, certain limitations will apply.
You may want to consider a strategy here called tax-loss harvesting. Tools like Wealthfront, for example, employ this to help reduce your tax liabilities and improve your investment portfolio.
Below are some common capital gain and/or loss situations and how they could affect your tax return:
The sale of your home
You home is probably the most valuable capital asset you will ever own. Does this mean that when you sell your home that you’ll be taxed on this sale?
The good news is that—for most of us—we will not be taxed on any gains on the sale of our home.
If, during the five-year period ending on the sale date, you owned and lived in the residence as your main residence for at least two years, you can exclude up to $250,000 from the gain on the sale. If you’re married and file jointly, you can exclude up to $500,000 on the gain—as long as you meet the same rules listed above for single filers.
What about claiming a loss on the sale of your home?
The quick and dirty answer is this: No, you cannot claim a loss on the sale of your home. This qualifies as a personal loss and personal losses are never deductible.
The sale of stock
The capital gain and loss rules for the sale of stock (or most other investment assets) is a little more clear-cut: You can both claim a loss on the sale of investment property and you will be taxed on any gains from the sale of investment property.
Now, before you get too excited about claiming all the losses on the free-falling values of any stock you own, remember this: You must sell the stock or investment property before you can claim a loss. So, if you have stock in your portfolio that you bought for $50.00 a share that is now worth $10.00 a share, you can’t just claim that loss. You’ll have to dump the stock before you can claim it. You can claim up to $3,000 in losses on your tax return. If your losses exceed $3,000, you can carry the losses forward to the next tax year.
There is one confusing, but important, rule on the sale of investment property, which has been coined the “wash sale rule”. This rule prohibits you from claiming a loss on the sale of stock if you buy the same stock within the 30 days before or after the sale. As I already mentioned, this rule is confusing and can be interpreted in different ways (for example, what exactly is “the same stock?”), so if you do have gains or losses from a wash sale, consult a professional for further information.
The sale of any personal asset
The category of “personal” capital assets is an all-encompassing category and includes almost everything you own. It includes items like your car to your television to your clothing to your vintage eight-track player.
When you sell an item, the selling price minus your basis in the item (usually the amount you paid for the item) will equal your gain or loss. Anytime you sell one of these items and the sale results in a gain, you will be taxed on this item.
However, the IRS prohibits taxpayers from claiming any personal losses on their tax return. So, if you sold your car and incurred a $3,000 loss, unfortunately, you won’t be able to claim that loss on your taxes. This is also the reason that you cannot claim a loss on your home.
If you’re unsure about what you can claim as a loss or what will be taxed as a gain, it’s best to consult a tax professional.
Capital gains and losses are a tricky subject that can confuse even the most tax-savvy person. If you keep detailed documents from all your financial transactions, your tax preparer should be able to make sense of your documentation and prepare the most accurate tax return for you.