Calculating capital gains is a relatively simple process of subtracting an asset’s purchase price (called its “basis”) from its sale price. If the sale price is larger than the basis, the difference is a capital gain. If, however, the asset decreased in value and is sold for less than its basis, the difference is a “capital loss.” When an investor sells more than one asset during the year, he or she adds all capital gains and capital losses of the same type (short-term gains with short-term losses, long-term gains with long-term losses). The totals are then taxed at their appropriate rates. If one investment type totals a gain and another type totals a loss, the loss can be used to reduce the value of the gain, ensuring the investor is not taxed for more income than was actually realized. The remaining net gain is taxed at the rate appropriate for its source.
If an investor has a net loss, it can be used to reduce his or her taxable income by as much as $3,000 a year. If a loss exceeds this amount, the excess can be rolled over from year to year to reduce the taxes on future gains or income. However, investors should be aware of the “wash sale rule,” an IRS regulation that prohibits claiming a capital loss if a “substantially identical” asset is purchased within 30 days of the loss sale. Effectively, the wash sale rule prevents investors from obtaining the tax benefits of a temporary loss when they intend to repurchase and hold the asset.
In some circumstances, capital gain is not determined using an asset’s original basis but rather its value when its ownership was transferred. This most often occurs during estate transfers when an asset’s basis is “stepped up” in value before being passed to an inheritor. This process effectively erases the original basis and creates a new one (determined by the current fair market value of the asset). The new, higher basis may increase estate taxes, but it will lower the capital gains taxes the inheritor must pay when the asset is sold.
This step up in the basis can be particularly important when it comes to property transferred to surviving spouses. When a spouse dies, his or her property automatically receives a step up in its basis value. Since a person can make a tax-free transfer of unlimited value to his or her spouse at death, property passing to the surviving spouse effectively gets a free upgrade in its basis. This can be a major boon to a survivor, who will be able to keep more of the profits if it becomes necessary to sell off property.