Capital gains tax in the United States

Capital gains tax in the United States

In the United States, individuals and corporations pay income tax on the net total of all their capital gains just as they do on other sorts of income. Capital gains are generally taxed at a preferential rate in comparison to ordinary income. This is intended to provide incentives for investors to make capital investments and to fund entrepreneurial activity. The amount an investor is taxed depends on both his or her tax bracket, and the amount of time the investment was held before being sold. Short-term capital gains are taxed at the investor's ordinary income tax rate, and are defined as investments held for a year or less before being sold. Long-term capital gains, which apply to assets held for more than one year, are taxed at a lower rate than short-term gains. In 2003, this rate was reduced to 15%, and to 5% for individuals in the lowest two income tax brackets. These reduced tax rates were passed with a sunset provision and are effective through 2011; if they are not extended before that time, they will expire and revert to the rates in effect before 2003, which were generally 20%.

The reduced 15% tax rate on eligible dividends and capital gains, previously scheduled to expire in 2008, was extended through 2010 as a result of the Tax Reconciliation Act signed into law by President George W. Bush on May 17, 2006. As a result:

*In 2008, 2009, and 2010, the tax rate on eligible dividends and long term capital gains is 0% for those in the 10% and 15% income tax brackets.

*After 2010, dividends will be taxed at the taxpayer's ordinary income tax rate, regardless of his or her tax bracket.

*After 2010, the long-term capital gains tax rate will be 20% (10% for taxpayers in the 15% tax bracket).

*After 2010, the qualified five-year 18% capital gains rate (8% for taxpayers in the 15% tax bracket) will be reinstated.

Technically, a "cost basis" is used, rather than the simple purchase price, to determine the taxable amount of the gain. The cost basis is the original purchase price, adjusted for various things including additional improvements or investments, taxes paid on dividends, certain fees, and depreciation.

The United States is unlike other countries in that its citizens are subject to U.S. tax on their worldwide income no matter where in the world they reside. U.S. citizens therefore find it difficult to take advantage of personal tax havens. Although there are some offshore bank accounts that advertise as tax havens, U.S. law requires reporting of income from those accounts and failure to do so constitutes tax evasion.

History of capital gains tax in the U.S.

From 1913 to 1921, capital gains were taxed at ordinary rates, initially up to a maximum rate of 7 percent.cite web |author=Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle (ed)|url= |title= Capital Gains Taxation entry from The Encyclopedia of Taxation and Tax PolicyProject|accessdate=2007-10-03] In 1921 the Revenue Act of 1921 was introduced, allowing a tax rate of 12.5 percent gain for assets held at least two years. From 1934 to 1941, taxpayers could exclude percentages of gains that varied with the holding period: 20, 40, 60, and 70 percent of gains were excluded on assets held 1, 2, 5, and 10 years, respectively. Beginning in 1942, taxpayers could exclude 50 percent of capital gains on assets held at least six months or elect a 25 percent alternative tax rate if their ordinary tax rate exceeded 50 percent. Capital gains tax rates were significantly increased in the 1969 and 1976 Tax Reform Acts. In 1978, Congress reduced capital gains tax rates by eliminating the minimum tax on excluded gains and increasing the exclusion to 60 percent, thereby reducing the maximum rate to 28 percent. The 1981 tax rate reductions further reduced capital gains rates to a maximum of 20 percent.

The Tax Reform Act of 1986 repealed the exclusion of long-term gains, raising the maximum rate to 28 percent (33 percent for taxpayers subject to phaseouts). When the top ordinary tax rates were increased by the 1990 and 1993 budget acts, an alternative tax rate of 28 percent was provided. Effective tax rates exceeded 28 percent for many high-income taxpayers, however, because of interactions with other tax provisions. The new lower rates for 18-month and five-year assets were adopted in 1997 with the Taxpayer Relief Act of 1997. In 2001, President George W. Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001, into law as part of a $1.35 trillion tax cut program.

Year 2008 income brackets and tax rates

Short-term capital gains are taxed as ordinary income rates as listed above. Long-term capital gains have lower rates corresponding to an individual’s marginal ordinary income tax rate, with special rates for a variety of capital goods.

Deferring and/or reducing

Exemptions from capital gains taxes (CGT) in the United States include:

Primary residence

Under 26 U.S.C. §121 an individual can exclude up to $250,000 ($500,000 for a married couple filing jointly) of capital gains on the sale of real property if the owner used it as primary residence for two of the five years before the date of sale. The two years of residency do not have to be continuous. An individual may meet the ownership and use tests during different 2-year periods. However, both tests must be satisfied during the 5-year period ending on the date of the sale. There are allowances and exceptions for military service, disability, partial residence and other reasons. "See" IRS Publication 523. The $250,000 ($500,000 for a married couple filing jointly) is not available to properties bought by 1031 exchange.

§121 provides no benefit if there is a loss on the sale of the property. One is not able to deduct a loss on the sale of one's home.

Capital losses

If an individual or corporation realizes both capital gains and capital losses in the same year, the losses cancel out the gains in the calculation of taxable gains. For this reason, toward the end of each calendar year, there is a tendency for many investors to sell their investments that have lost value. For individuals, if losses exceed gains in a year, the losses can be claimed as a tax deduction against ordinary income, up to $3,000 per year. Any additional net capital loss can be "carried over" into the next year and again "netted out" against gains for that year. Corporations are permitted to "carry back" capital losses to off-set capital gains from prior years, thus earning a kind of retroactive refund of capital gains taxes.

Deferment strategies

Capital gains tax can be deferred or reduced if a seller utilizes the proper sales method and/or deferral technique. The IRS allows for individuals to defer capital gains taxes with tax planning strategies such as the Structured sale (Ensured Installment Sale), charitable trust (CRT), installment sale, private annuity trust, and a 1031 exchange.

* Deferred Sales Trust - Allows the seller of property to defer capital gains tax due at the time of sale over a period of time.
* 1031 exchange - Defer tax by exchanging for "like kind" property. Pay capital gains when it is realized.
* Structured sale annuity (aka Ensured Installment Sale) - Defer and reduce capital gains tax while gaining safety and a stream of guaranteed income.

* Charitable trust - Defer and reduce capital gains by giving equity to a charity.
* Installment Sale - Defer capital gains by taking payments from a buyer over a period of years. No protection from buyer default.
* Self Directed Installment Sale (SDIS) - Allows for the deferral of capital gains taxes while removing the risks from buyer default under a traditional installment sale. [ [ Self Directed Installment Sale | Capital Gains Deferral ] ]
* (historical) Private annuity trust - No longer a valid tax deferral tool.


No offset for gains due to inflation

The capital gain upon which the tax is calculated is not inflation adjusted. Thus for example, a gain that is entirely due to inflation (currency debasement), is not a real gain at all, nevertheless this illusory gain is taxed. Inflation has not been anywhere near 15% since the 1970's, and inflation levels are not neccessarily positively correlated with capital appreciation.

Rate not indexed to income

Some critics call the capital gains tax a regressive tax when its rate is lower than income tax (as is the case in higher tax brackets in the US). They argue that there is no justification for a lower tax on earnings from capital gains than from interest or dividends or from any other kind of income. [ [ A capital gains tax cut will spur the economy ] ]

Libertarian view

Others criticize the capital gains tax simply because it is a tax. Adherents of smaller government philosophies, such as libertarians and some conservatives, believe that most or all taxes should be dramatically reduced, since much of the revenue is simply re-distributed to other individuals, which they hold to be morally equivalent to theft, or is lost due to government's inefficiency relative to competitive markets. [ [ The Flimflam of Income-Tax Denial ] ] .


External links

* [ The Labyrinth of Capital Gains Tax Policy: A Guide for the Perplexed] (1999), Brookings Institution Press.
* [ Deloitte Tax Country Guides]
* [,,id=98491,00.html IRS "Like Kind Exchanges Tax Tips"]

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