Taxes come in many forms, none of them pleasant. And while it may sound trite to say some taxes are arguably better (or less bad) than others, it is true that levies on capital gains can take less of a bite if the taxpayer is cued in to the rules. It is also true that those rules can be complicated, so here is a little refresher.
The word “capital” has an interesting origin. Originally from the Latin “caput” for “head,” capital referred to the chief or most important city in a region or country. During the early 17th century, the word came to mean more broadly a thing of greatest value or importance. The word came to English from French and Italian financiers referring to “principal possessions” in the sense of wealth used to conduct a business venture. Capital in the modern sense refers to assets invested in expectation of a profit through increase in value. That increase or accumulation of additional value is called a “capital gain” and is treated differently than wage income by the taxman.
Importantly, taxpayers have some control over when to create a taxable event by selling an investment. When an asset like a stock or piece of real estate is sold for a sum higher than the initial purchase price, the seller is said to realize a capital gain. Only then is the profit taxed. Appreciation in value of an asset still held is called an unrealized gain, and taxation is deferred until the eventual sale of the asset.
Unlike salaries and wages, capital income is generally considered to be a return in exchange for putting assets at risk. Note that not all capital investments result in a favorable outcome (ask any Lehman Brothers stockholder), and assets sold below the purchase price result in capital losses. As recompense for the capital risk, the tax code allows investors to offset gains with losses incurred in a tax year and to carry over any excess losses to offset future gains.
The code also makes a distinction based upon the holding period. Capital investment over a long horizon is necessary for economic development and income growth in an economy. To encourage a longer capital commitment, the current tax code penalizes short-term capital gains (less than a one-year holding period) by taxing the gains at ordinary income tax rates. Gains realized after more than a year are levied at special reduced tax rates specific to long-term capital gains.
Long-term capital gains rates have varied historically since the adoption of the 16th Amendment in 1913 (aside: the top rate in 1913 was 7%). The current structure incorporates three brackets based upon adjusted gross income and remains quite favorable to long-term investors. The top rate of 20% is far below the highest ordinary income tax rate of 37% and applies to households with taxable income above $517,000. However, most taxpayers with joint incomes above $83,350 but below the ceiling are subject to a 15% rate, and households with AGI below $83,350 pay no capital gains tax at all. This is important to know, especially for retirees with limited ordinary income but appreciated assets.
Another distinctive feature is the ability of taxpayers to defer the gains until their death, at which time the tax liability is erased and heirs acquire the assets with an adjusted cost or “basis” that is stepped up to the present market value. Relaxation of estate tax rates since 2010 have focused more attention on the revenue loss to the Treasury from that 100-year-old tax break, but resistance to change has been substantial and revocation of the provision for stepped up basis seems improbable in the near future.
It is important to maintain good records of the cost basis in your capital investments to ensure the minimum possible tax wallop upon the sale of the assets. It’s also important to track the basis of each lot separately if you acquired stocks over time in multiple transactions, as you can choose which tax lots to sell in order to minimize the tax. And don’t look now, but April 15 is just around the corner.
Christopher A. Hopkins is a chartered financial analyst in Chattanooga.
Chris Hopkins of Barnett & Co.