NIBM - Tax Tips - The Wash Sale Rule Part Four

Tax Talk 4: Capital Gains

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March 7, 2004 Bret A. Espey, CPA, Espey Accounting Services

"A long, long time ago..."

….in a galaxy far, far away, I promised to write a Tax Talk article about Capital Gains. Earlier this year, I decided it was time to “get cracking”. Then, as luck would have it, the folks at the IRS changed the tax rules again (Stop the presses!). Many of these changes (at least on the surface) are advantageous to you, the taxpayer, or at least give you more tax planning options.

As we head into tax season, the time is ripe to pluck this subject from the proverbial “hold file” and serve up a discussion on the dreaded capital gains tax rules. In this article I will outline:

The definition of a capital asset
The definition of a capital gain or loss
How gains and losses are netted together when figuring the gains or losses
The new tax rates for 2003 and a comparison to the old rates
How these rules might affect you
Dividend tax rates - Part of these new regulations includes new rates for dividends, which are now to be taxed at the new capital gains rates. I provide a brief synopsis of the new ruling, and links to helpful information so you can untangle the new rules.

1. Defining moments

So, what is a Capital Gain or Loss? By definition, it is any gain or loss arising from the sale or exchange of a capital asset. “Great”, you say, “so what is a capital asset?” Generally, any property owned for personal use, or for investment purposes is a capital asset. This means stocks, homes, furniture, cars, collectibles, jewelry, and your Aunt Matilda’s corset that was willed to you (to name just a few). It is not, however:

Inventory held for sale to customers as part of your business
Supplies used in a trade or business
Receivables from a business
Depreciable property or real estate used in a trade or business (fully depreciated or not)
Certain commodities derivate financials instruments held by a dealer
Certain hedging transactions entered into as part of the normal course of a trade or business
…and others. We will discuss some of the exceptions to the rule and how they are affected by the capital gains tax code, but for now let’s assume we’re talking about a stock purchase and sale, to build a groundwork.

2. The basis of it all

“Okay, so now I know I owned a capital asset, and because I sold it I have some kind of gain or loss. What now?” Now, we determine the gain or loss. Again, we’re talking about stock or option sales for now. You probably have heard the term “basis” kicked around a bit – this is, in its simplest form, what you originally paid for the stock, plus any costs (for example, transaction fees) that you paid as part of the purchase transaction. Once you know the basis, then the gain or loss is figured by subtracting that basis from your sale proceeds. The sales proceeds are determined by what you received for the stock, less any commissions or other fees. The difference between the two numbers is your gain or loss.

'Basis' is, in its simplest form, what you originally paid for the stock plus any costs paid in the transaction.

What is the basis if you receive stock as part of a distribution from someone who has passed away? Generally, Your basis in that stock is the fair market value of that stock on the date of death.

Also note that the Wash Sale Rules can affect basis as well. I have several articles on this subject – I suggest you read these by clicking here, especially if you buy and sell many shares of the same stock (or types of stock) in succession. The “Wash Sale Part I” is the place you want to start.

3. The long and short of it

Once you know the gain or loss, you have to do something with them for your taxes. The first thing you need to do is determine what the stock’s “holding period” was. This is crucial to the tax picture, as you’ll see in a minute. The holding period begins the day you buy the stock. It ends the day you sell it. Both the buy date and sell date are included in determining the holding period. It really is that simple.

Items that were held “short term” are those held for less than one year (365 days). “Long-term” holdings are those held for one year or more. Since I can hear the leap-year question coming from a mile away (2004 is a leap year after all), here’s how I’d do it - If the short-term period falls over a period of time which includes February 29th, 1 year equals 366 days. The character of the gain or loss from your sales depends solely on this holding period.

Now that you know the holding period, you can fill out Schedule D on your tax return (for those who have attempted to fill out one of these gems, the pain is coming back, isn’t it? Brace yourself – it’s more complicated this year). Here is where the netting of gains and losses is done. The form, if stepped through properly, does all the work for you. This is what happens on the Schedule D:

All Short-term gains and losses are combined together, to come up with your net short-term gain or loss.
All Long term gains and losses are combined together, to come up with your net long-term gain or loss.
The two numbers are then combined. If the overall result is a loss, then you determine how much of that loss you get to show on your tax return. The limit is $3,000 in any given year. Any unused loss is carried over to following years. The loss goes straight to your 1040 as a capital loss, which offsets ordinary income (at whatever tax rate you are at – but see an exception below).
If the overall result is a gain, then the gain is split between gain prior to May 6, 2003, at that received on May 6th and after:
For net long-term gain received before May 6, 2003, the old capital gain rates are applies (see “old rates”, below)
For net long-term gain received on May 6, 2003 or after, the new capital gains rules apply (see “new rates”, below)
Short-term gains are taxed at whatever your marginal tax rate is

The above is a bit simplified – Section IV of Schedule D is set up to do all the tax calculations for you, and determines all the proper tax rates to apply to all this. It’s actually a clever (albeit complicated) form, especially for 2003 given the “split-rule” year. If you prepare this form by hand, go through it very slowly and carefully – it’s very easy to get the wrong numbers in the wrong places (trust me, I do this for a living and always have to double-check myself).

Old Rates:

For those gains on stock sold prior to May 6, 2003, the following rates apply:

20% - Long-term capital gains rate for taxpayers in the 25% bracket or above.

10% - Long-term capital gains rate for taxpayers in the 10% or 15% brackets

8% - Long-term gains on stock held longer than five years, for taxpayers in the 10% or 15% brackets

Short-term gains: Taxed at the taxpayer’s normal tax rates, just like ordinary income.

New Rates:

For gains on stock sold on May 6, 2003 or after, the following rates apply:

15% - Long-term capital gains rate for taxpayers in the 25% bracket or above.

5% - Long-term capital gains rate for taxpayers in the 10% or 15% brackets (note: there is no longer an 8% rate for stocks held greater than 5 years, because the new rates are more advantageous)

Short-term gains: Taxed at the taxpayer’s marginal tax rate, just like ordinary income.

4. Opportunities abound

There are tax-planning opportunities in all this, of course. Short-term losses are generally better for you than long-term losses when you have short-term gains to offset. Why? Because short-term gains are taxed at your regular tax rate (which is always higher than the long-term cap gains rate).

If you are thinking of selling a losing stock you have held almost a year, make sure to sell it before the year is up. This is one of the simplest and most lucrative tax-related investing decisions you can make. Never let a short-term loss become a long-term loss without good reason.

The more short-term losses you have to offset short-term gains, the lower your tax will be, ultimately. This could be important if you have a losing stock that you want to sell, and its one-year anniversary is fast approaching. If you had a bunch of short-term gains that year, it is particularly advantageous for you to sell it before its one-year anniversary to take advantage of this rule. Bottom line: If you have short-term gains, sell stocks to increase your short-term loss (if that makes sense for your situation), to reduce your tax.

Example 1:

John has short-term capital gains of $1,000, and long-term capital gains of $1,000 so far in 2003. It’s getting toward the end of 2003 and he’s doing some tax planning. He’s trying to figure out the best time to sell his stock in XYZ, which he bought on December 27, 2002. Let’s say he decides to sell the stock on December 30, 2003, and it generates a loss of $1,000. Let’s also assume he’s in the 27% tax bracket. Because he held the stock greater than one year, the long-term loss nets out against the long-term gain, leaving him with the short-term gain of $1,000. This will be taxed at the marginal 27% rate along with other income, or $270.

Example 2:

Same assumptions as above, except John wisely understands that he’d much rather reduce the short-term gain. Let’s say he sells the stock on December 25th instead, and produces the same $1,000 loss. Now the loss is short-term, and will be offset against the short-term gain of $1,000. The long-term gain of $1,000 is left, and since the sale occurred after May 5, 2003, the rate for his long-term gain is now 15%. His tax on the long-term gain is $150. He saved $120 (almost half) merely by selling the stock three days earlier. There is risk here, because much can happen in three days. But if you think the stock price will remain stable over three days (or three weeks, or whatever time period you’re looking at), this becomes an important tax-reduction tool.

There’s one other catch to long-term capital gains. Once you net all your long-term and short-term activity together, if you have a net overall loss for the year, the losses go on your return and affect ordinary income (meaning all the losses basically get treated as a short-term loss.) However, the long-term portion of those losses is capped out at 28%. So, if you are in a tax bracket higher than 28% (one of the top two brackets), you lose the benefit of these losses affecting your ordinary income at your higher tax rate. This is another way long-term losses aren’t as good as short-term losses.

5. "There are always exceptions to the rule"

In our discussion above, we are explaining the capital gains rules as though we bought and sold stock. The rules above generally apply to any capital gains. There are always exceptions to the rules as you probably know. Review the definition of a capital asset above, then note the following exceptions. These are very brief summaries of the exceptions, so please see your tax advisor for more information.

Collectibles – this might include art, coins, stamps, if held more than one year, any gain on the sale of collectibles is taxed at the taxpayer’s marginal tax rate, to a maximum of 28%.
1202 (or “Qualifying Small Business Stock”) gains –50% of the capital gain from such stock is treated as ordinary income, to a maximum of 28%. The other 50% is excluded from income. Among other limits, the stock must be in a C-corporation, must have been issued after 8/10/93, and must have been held for at least five years. This is a tricky one with a bunch of rules on this, so definitely consult your tax advisor if you think you qualify.
1250 gain – This refers to gains from certain real property (real estate and the like). Any gain that is the result of recapturing straight-line depreciation is taxed at a maximum tax rate of 25%. If the taxpayer is in a lower bracket, the lower rate applies. This is another tricky one with a bunch of rules, so get some help if you think you qualify.
Personal use property – Gains on the sale of property held for personal use are considered capital gains and subject to the more advantageous rules, but the loss is never deductible. You know that corset you received from Aunt Matilda? Sorry, but if you sell it at a loss, you don’t get to offset that against any gains. Besides, it kind of looks good on you.

The bottom line on these new capital gains rules is this – make sure you are reviewing your portfolios regularly, paying special attention to your gains and losses at any point in time, and the holding period (or potential holding periods) of your stocks. Knowing this information in light of the new rules will greatly increase your chances of paying the lowest amount of tax possible.

3. New Dividend Rules

In 2003, congress enacted new legislation (along with the new capital gains rules) that allows folks receiving dividends, to have them taxed at the new capital gains tax rates noted above.

On its surface, this is a great change because:

It encourages investing by giving folks who own (or wish to own) stocks a tax break on dividend income.
It eliminates some (but not all) of the “double-taxation” effect felt by a corporation and its investors. In a nutshell, a corporation does not take a deduction for dividends paid, meaning it effectively get taxed on that money. The investor also takes the dividends as income and pays tax accordingly. By applying the lower rates, the “double taxation” effect is reduced. (It’s not eliminated of course, because you’re still being taxed, but hey….it’s a good trend).
It could also make a C-corporation a somewhat more advantageous business entity for those setting up a new business, depending upon on the individual, the business, and other factors.

Also, note that the change in dividend tax rates is effective January 1, 2003 (as opposed to actual capital gains, to which the new tax rates only apply for capital gains recognized after May 6, 2003). This makes the rule much easier to apply.

Sounds straightforward, right? Unfortunately, there are many exceptions to these new rules (for example, what you might think is a dividend, may not be eligible for the lower rates).
There are many great articles already written on this subject, and rather than re-state them here, I suggest you link to them below and read them.

Small Business & Tax Management - outlines in very clear terms what types of dividends are and are not included. It also discusses some other peculiar wrinkles about how dividends may not be eligible for this preferential tax treatment, how they could potentially be treated as ordinary dividends, and other thorny matters.
Mercury News – states the limitations, and discusses a particular glitch that affects dividends for those employing a common strategy – buying stocks the day before the ex-dividend date to receive the dividends.
MSNBC News – Goes into a little greater depth for some situations. For, example, it talks about positions hedged by a “put” or “collar”. It also discusses some of the Alternative Minimum Tax (AMT) ramifications of the new law.

THANKS – I’m interested in your questions and comments. Perhaps there is a particular tax question you’d like to ask. Send it my way and I’ll see if we can’t incorporate that into future articles. If I get enough questions I may provide a "question and answer" forum in the future. You can contact me by

The tax advice given here is based on an interpretation of the laws at the time the article was written, and should not be construed as advice given by NIBM. The above interpretation is based upon best information and an analysis of then-current interpretations of the tax code. The strategies discussed may not apply to your particular situation. We strongly suggest speaking with a tax advisor for specific questions and before making specific trading decisions based upon the information covered in this article.