Tax Treatment of Capital Gains and Losses

A taxpayer does not realize gain or loss on the value of property for federal income tax purposes until the property is sold or otherwise disposed of. If the property is considered a capital asset that is sold or exchanged, the resulting loss or gain on the sale is considered a capital gain or capital loss. There are specific tax rules applicable to the recognition of capital gains and capital losses. These rules may prevent such gains or losses from being recognized or provide for gains to be taxed at a lower rate if they are recognized.

There must be a sale or exchange of a capital asset for a taxpayer to be subject to the rules regarding capital gains and losses. The term "capital asset" is not specifically defined by the Internal Revenue Code. Rather, section 1221 sets forth classes of property that do not qualify as capital assets. Under section 1221, capital assets include all property that is held by a taxpayer, whether or not the property is connected with the taxpayer’s trade or business, except for:

  • Stock in trade, inventory or property held primarily for sale to customers in the ordinary course of business
  • Depreciable property used in a trade or business or real property used in the taxpayer’s trade or business
  • A copyright; literary, musical, or artistic composition; letter or memorandum; or similar property (if it meets certain listed requirements)
  • Business accounts or notes receivable in the ordinary course of business
  • Certain publications of the US government
  • Commodities derivative financial instruments held by a commodities derivatives dealer (with certain listed requirements)
  • Hedging transactions that are so identified by the close of the day it was acquired, originated or entered into
  • Supplies of a type regularly used or consumed by the taxpayer in the ordinary course of trade or business

Again, to be subject to the rules regarding capital gains and losses, there must be a sale or exchange of a capital asset. "Sale" is generally defined as disposing of property for money (cash or its equivalent) or the recipient’s promise to pay. "Exchange" generally refers to a transaction in which assets are transferred. In an exchange, the taxpayer disposes of property and acquires different property in return. The sale or exchange must be a bona fide transaction and not merely a sham.

Capital gains are taxed at a lower rate than other types of income. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the old 20% and 10% capital gains rates to 15% and 5% (or 0% for gains recognized after December 31, 2007). The types of income that are subject to the preferential capital gains rates were also expanded to include certain qualified dividend income. The Tax Increase Prevention and Reconciliation Act of 2005 extended the reduced rates on capital gains and dividend income until December 31, 2010.

In sum, if a taxpayer realizes a gain or loss on the sale or exchange of a capital asset, the tax rates and rules for capital gains and capital losses apply. A taxpayer who realizes a gain on the sale of a capital asset will be taxed at the lower capital gains tax rate.

Preparing for a Meeting with Your Tax Attorney

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Preparing for a Meeting with your Tax Attorney

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